Money Management

I have been giving this a lot of thought and figure this is the best way to contribute to HSM.
Money Management, back testing, and application.
It is a very lengthy subject and I will share some ways to become a successful trader and establish a winning system and individual trading pattern that may fit your personality.

One of the most difficult qualities of being a successful trader is learning good money management. It’s completely possible - and actually pretty common - to see people turn out to be right on a high percentage of their trades and still lose money. How is that possible? If you don’t use good money management by locking in profits, taking small losses on the picks you’re wrong about, and controlling your use of margin, eventually you’ll lose it all, no matter how good a trader you are.

Once you've decided your trading objective, and what market you'll focus on, youll need to develop a stock trading system. Hundreds of different stock trading systems already exist, and you can certainly learn about or you can develop your own. Whats important is that you can objectively evaluate the stock trading system to ensure it meets your needs and that it performs well.

If you treat trading like a business it will pay you like one. if you don't know anything about the business, All traders should find themselves a coach, or a mentor. Someone who can help them spot the errors in their system that they might not have noticed. An outside point of view can help you avoid other costly mistakes, and greatly increase your profits.
I would like to point out how serious I take this business, in comparison, if you wanted to learn how to fly a plane you would not buy a book and read it over the weekend and expect to fly a plane on monday would you?
well the same goes for the Stock Market
I love to see people succeed and profit from the stock market, but I am also here to make money and there is a buyer and a seller for every stock and option, and I am here to take that money. Those are pretty harsh words but nothing less than the truth.

Creating and sticking to a strategy can enhance your trading results.

Money Management is the process of determining how much money to invest per trade, how often to trade and what your total portfolio or equity growth rate should be

Back testing is the process of analyzing how a system would responded in the past

Application is the process of inplimenting your system

The risk/reward ratio represents the profit you can expect from winning trades and the losses you can expect from losing trades within a system

the win/loss ratio represents the number of sucessful trades you can expect within a trading system

the expectancy ratio represents the profit you can expect per trade within a trading system

Money Management

Money management is the system by which you determine how much to invest in any given trade. the reason most new traders fail does not usually relate to their lack of understanding of technical indicators. it is mostly due to lack of poor money management. you can make a mistake in your analysis and the market could be fairly forgiving, but you can't make mistakes in
Money management and expect to survive.

New Investors tend to participate in seesaw money management. new traders find a strategy or technique to trade, and they begin small. After a few wins, the trader invests a larger portion of their portfolio in the subsequent trade and lose. Because the trader invested much more money in the loser than in the previous winners, the loss out paces the winners and the trader panics. The amount of money placed in the subsequent trade is much less because the trader is spooked and does not want to lose again. After a few winning trades the trader repeats the process and invests more to once again lose. You don't have to repeat that scenario very many times before you have lost a significant part of your portfolio.

The problem of seesaw money management is obvious. A trader does not have a system telling them how much money they should invest. they inevitably invest more money when they are due for a loser and invest less money when they are due for a winner.
We will discuss some basic rules next.

Even aggressive traders won't put more than 50% of their available balance in the market at one time.the rest may be reserved for fixed income,such as annuities, real estate, or other investments.
trading can be quite the roller coaster ride, and having a reserve outside the market helps smooth the emotional bumps of the ride.

You should look for low risk investments to offset your high risk investments.
choose what you are most comfortable with, such as risk - free investments (government bonds). You should regularly reevaluate your trading account to adjust the balance between aggressive and conservative positions as your trading account grows. twice a year will do.

Decide beforehand how much you are willing to risk in a single trade.
a successful trader will define risk as the Maximo amount of money they are willing to lose in a bad trade. if you are willing to lose a $1 in a trade, then your maximum risk is a dollar. although your maximum risk is only a dollar the stock itself may actually cost much more. if you bought a 425 stock and you set your stop loss at $23, your risk is $2, not $25.
You maximum risk is not actually the place you will exit the trade, that is the safety net you have in place in case things go wrong.

How much risk you are willing to take is useful when deciding how much of your total portfolio you are willing to invest in a trade.
most traders use a simple formula of risking no more than 1% - 2% of the total portfolio in any trade.

lets say you have 100,000, if you apply the 2% formula, you would be willing to risk up to $2000 in a single trade. How many $20 shares can you buy without risking more than $2000. new Traders would assume that they could only buy 100 shares $20 X 100 = $2000. What you may forget as a new trader is that the number of shares you buy is a function of how much they are willing to risk, not how much they are willing to invest. Imagine you have set a stop loss at $18 on this trade, that means you are really risking $2 per share. Knowing this, you can know calculate how many shares you can purchase by dividing $2000 by $2 per share. using this formula you could buy 1000 shares of stock (2000 - divided by -$2 = 1000).
this formula helps eliminate the guess work associated with trying to determine what you are willing to invest from your total portfolio in a single trade.

Assume you are willing to risk 2.5% of your $100,000 portfolio or $2,500.
also assume you are evaluating stock worth $40. and you set your stop loss at $37. a difference of $3 Now divide $2,500 by $3.00 which gives you 833 shares. once you have determined the number of shares (833), multiply that number by the cost per share, which gives you $33,320 (833 x $40 = $33,320)
Now you can see you know exactly how much of your total portfolio to invest if you want to risk $2,500.
That is a major investment of more than 33K, if that is not comfortable, lower the amount you are willing to risk to 1% or less.
What ever the amount keep it low and consistent.

I'll give you a quick run out on option trading, assume you are buying a $50 at-the-money option for 4.00 a share or per contract. You decide to set a 50% stop loss (maximum!) 30% is my personal rule.
We will use the 50% in this example. $2.00 per share or $200.00 a contract.
now divide 2,500 by 200 which gives you 12.5 contracts (you have to use whole numbers so we will take the lesser value which is 12).
Once you have determined the number of contracts (12) multiply that number by the cost of the contract ($400) which gives you $4800.00

you will notice that this system of managing risk automaticly accounts for higher-risk investments. the more you are willing to lose in a worst case senerio, the less of your porfolio you will be able to invest.
This self ajustment forces a level of dicipline on you and your trading system.
if you fail to establish a money management system, your allocation could become detrimental to your account.

It is important to note that most traders will have very small gains or no gains at all if they are always investing the same dollar amount in each trade. Typically a trader will go on a run of winners and then a run of losses. The winners are not evenly distributed, and this grouping can be difficult to deal with if you are always investing the same dollar amount. Investing a constant percentage of your account is much more affective than investing a constant dollar amount.
Investing on a percentage means that if you are on a losing streak, you will be investing less and less with each trade, which will reduce your losses for each subsequent trade.

If you are on a winning streak, you will be investing more and more with each trade, which will increase the gains each subsequent trade.
These streaks will happen, but will allow you to get all the value you can out of them.

Stop-Loss Orders

The first rule of successful trading is, “Cut your losses short.” Losses are inevitable; no one is immune to losses. A stop-loss order should be placed with every trade you enter, whether you trade long or short. A stop-loss order gives you insurance that a little loss won’t turn into a bigger loss, and that you’re trading capital won’t be tied up in a losing stock. So you don’t have to worry about missing that, “can’t lose sure fire trade” that you always find when you don’t have the funds available to trade it.

Stop orders are used to initiate trades, lock in profits and limit losses on open trades. Stop-loss orders can be used to manage the risk on your trades. Every trader should use a protective stop; they are a necessary part of trading. A stop-loss order is placed at a price level that you want to exit a trade. When you call your broker and place a stop-loss order, you are informing your broker if the market trades at a predetermined price, then the stop order is to become activated and the order is to be executed at the current market price.

The Stop-Loss (Part 1)
Today is the day you are going to trade your first stock. You’ve gone to a stock investment seminar, studied the books and trading materials and you have even been practicing paper trading. You’re ready! At least that’s what you keep telling yourself; after all, the seminar speaker was just a kid and if he can do it so can I. As soon as you find that winning stock, the one that’s going to pay off your mortgage, you gather up your courage and call your broker to enter the trade. Now what do you do? Do you just sit around and wait for the stock to go up and count the profits? What happens if the stock falls apart and quickly changes direction, are you ready for a big loss? Entering into the trade is the easy part, learning how to protect and manage your trade is the challenge. That’s where the stop-loss order helps; using a stop-loss order assures you that your first trade won’t be your last trade.

The first rule of successful trading is, “Cut your losses short.” Losses are inevitable; no one is immune to losses. A stop-loss order should be placed with every trade you enter, whether you trade long or short. A stop-loss order gives you insurance that a little loss won’t turn into a bigger loss, and that you’re trading capital won’t be tied up in a losing stock. So you don’t have to worry about missing that, “can’t lose sure fire trade” that you always find when you don’t have the funds available to trade it.

Stop orders are used to initiate trades, lock in profits and limit losses on open trades. Stop-loss orders can be used to manage the risk on your trades. Every trader should use a protective stop; they are a necessary part of trading. A stop-loss order is placed at a price level that you want to exit a trade. When you call your broker and place a stop-loss order, you are informing your broker if the market trades at a predetermined price, then the stop order is to become activated and the order is to be executed at the current market price.

If you are long a stock, a sell stop order is positioned below the current market price. If the stock’s price declines and reaches the price level of the stop order, the order is triggered and sold as a market order. For example: If you buy 100 shares XYZ stock at the current market price of $32 and place a “sell stop order” at $31.25 (below the current market price), should the price of the stock drop to $31.25 a market order is then triggered to sell the stock. Remember with a market order, you may not be filled at the price you expected; your sell order is activated at $31.25, but your actual fill price could be much lower resulting in slippage. Slippage is the price you had hoped to be filled at verses the actual price you received.

If you are short a stock, a buy stop order is positioned above the current market price. If the stock’s price rallies and reaches the price level of the stop order, the order becomes active and a buy market order is generated. Using stops in this manner will help limit your losses or lock in your profits.

Stop-loss orders offer you an insurance policy against catastrophic losses and help preserve your trading capital. Sometimes stop-loss orders may seem like a waste of money because you may be exiting trades prematurely, and that may be maddening. The regular use of stop-loss orders can guarantee that no single trade will ever wipe you out and end your trading permanently.

It is very important to grasp that using a stop-loss is the best thing a trader can do. Too many times, a mental stop-loss never gets carried through; the trade turns and the trader is faced with crippling losses. By placing actual stops, you are declaring to the market and yourself that if you are wrong, you’re going to cut your losses and run. A well-placed stop-loss can be a lifesaver; it guarantees you’ll survive to trade another day.

Never use a "STOP LIMIT" ORDER, it has to hit that exact price and could ultimately skip over it.
But more important, regular stop orders are not seen buy the market because they are really market orders.
"Stop Limit" orders are on the board for everyone to see! They may go after it.

Thank you there is much more to come. Some people use stop orders only to get frustrated because they get stopped out often. this can be frustrating and move people into the "mental stop loss" mode.
Hey you are not the only one getting stopped out, and no the stop order doesn't have your name on it.
You can go through a period where every trade gets stoped out! Man how frustrating that is!!!
Don't break your rules stick by them.

The Obvious Secret

It's really not a secret but I will reveal some things here that will make you a better trader when it comes to stop losses.
Yes the "PROS" do know where these stops are based on simple rules.

Each stock has its own 52-week high and its own 52-week low, these are important closely watch levels. If the stock approaches one of these significant levels, it catches the attention of sharp traders because they know that there will be buy stop-loss orders above the 52-week high and sell stop-loss orders below the 52-week low.

Also recent major highs and recent major lows of the last several months are a preferred level for traders to place stop-loss orders.

The weekly high and low points are a great place to find stop-loss orders. Many traders will enter or exit a stock as a weekly high or low point is violated. Again, you’ll find buy stop-loss orders above the weekly high and sell stop-loss orders below the weekly low.

The previous day’s price consists of a high, low and closing price, and it is a very popular place to put a stop-loss order. These prices are important because they are often used to calculate the next day’s value area, pivot points and trading range. Once a stock breaks out of its value area, it is likely to continue its trend; stop-loss orders are a good way to protect your trade should one of these points be penetrated. There will be buy stop-loss orders above the previous day's high and sell stop-loss orders below the previous days low. In regards to the previous day’s closing price, buy stop-loss orders will be placed above and sell stop-loss order will be placed below this area.

Often a stock’s trading range is determined during the first 30-minutes of the open. A new high and low are established, and trading signals are generated once one of these areas is penetrated. So, there will be buy stop-loss orders above the high of the first 30-minutes and sell stop-loss orders below the low of the first 30-minutes.