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Money
management is a very confusing term.
When we looked it up on the Internet, the only people who used
it the way that Van was using it were the professional gamblers.
Money management as defined by other people seems to mean controlling
your personal spending; giving money to others for them to manage,
risk control, making the maximum gain, plus 1,000 other
definitions.
To
avoid confusion, Van elected to call money management "Position
Sizing." Position
sizing answers the question, "how big
of a position should you take for any one trade?"
Position
sizing is the part of your trading system that tells you “how much.”
Once
a trader has established the discipline to keep their stop loss on
every trade, without question the most important area of trading is
position sizing. Most people in mainstream Wall Street totally
ignore this concept, but Van believes that position sizing and
psychology count for more than 90% of total performance (or 100% if
every aspect of trading is deemed to be psychological).
Position
sizing is the part of your trading system that tells you how many
shares or contracts to take per trade. Poor position sizing is
the reason behind almost every instance of account blowouts.
Preservation of capital is the most important concept for those who
want to stay in the trading game for the long haul.
Imagine
that you had $100,000 to trade. Many traders (or investors,
or gamblers) may just jump right in and decide to invest a substantial
amount of this equity ($25,000 maybe?) on one particular stock
because they were told about it by a friend, or it sounded like a
great buy; or perhaps they decide to buy 10,000 shares of a single
stock because the
price is only $4.00 a share (equating to $40,000).
They
have no pre-planned exit or idea about when they are going to get
out of the trade if it happens to go against them and they are
subsequently risking a LOT of their initial $100,000 unnecessarily.
To
prove this point, we’ve done many simulated games in which
everyone gets the same trades. At the end of the simulation, 100
different people will have 100 different final equities, with the
exception of those who go bankrupt.
And after 50 trades, we’ve seen final equities that range
from bankrupt to $13 million—yet everyone started with $100,000
and they all got the same trades.
Position
sizing and individual psychology were the only two factors involved.
Van says that this just shows how important position
sizing is.
So
how does it work?
Suppose
you have a portfolio of $100,000 and you decide to only risk 1% on a trading idea that you have.
You are risking $1,000.
This
is the amount RISKED on the trading idea (trade)
and should not be
confused with the amount that you actually INVESTED in the trading
idea
(trade).
So
that’s your limit, you decide to only RISK $1,000 on any given
idea (trade). You can risk
more as your portfolio gets bigger, but you only risk 1% of your
total portfolio on any one idea.
Now
suppose you decide to buy a stock that was priced at $23.00 per
share and you place a protective stop at 25% away, which means if
the price drops to $17.25 you are out of the trade.
Your risk per share in dollar terms is $5.75.
Since your risk is $5.75, you divide this value into your 1%
allocation (which is $1,000) and you are able to purchase 173
shares, rounded down to the nearest share.
Work
it out for yourself, so you understand that if you get stopped out
of this stock (i.e., the stock drops 25%), you will only lose $1,000
or 1% of your portfolio. No one likes to lose, but if you didn't
have the stop and the stock dropped to $10.00 per share, you can see
how quickly your capital vanishes.
Another
thing to notice is that you will be purchasing about $4000 worth of
stock. Work it out for
yourself. Multiply 173
shares by the purchase price of $23.00 per share and you’ll get
$3979. It would probably
be around $4000 when you add commissions.
Thus,
you are purchasing $4000 worth of stock, but you are only risking
$1000 or 1% of your portfolio.
And
since you are using 4% of your portfolio to buy the stock ($4000),
you can buy a total of 25 stocks this way without using any
borrowing power or margin, as the stockbrokers call it.
This
may not sound as “sexy” as putting a substantial amount of money
in one stock that “takes off,” but that strategy is a recipe
for disaster and very rarely happens. Therefore it is best left on
the gambling tables in Las Vegas.
To
continue to trade and stay in the markets over the long term,
learning position sizing and protecting your initial capital is
vital.
Van
believes that people who understand position sizing and have a
reasonably good system can usually meet their objectives through
developing the right position sizing strategy.
Position
Sizing—How much is enough?
Start
small.
So many traders that are trading a new strategy start by risking the
full amount that they plan on using for the long term with that
strategy. The most frequent reason given is that they don’t
want to “miss out” on that big trade or long winning streak that
could be just around the corner. The problem is that most
traders have a much greater chance of losing than they do of winning
while they learn the intricacies of trading the new strategy.
Therefore, start small (very small) and minimize the “tuition
paid” to learn the new strategy. Don’t worry about transactions
costs (such as commissions), just worry about learning to trade the
strategy and follow the process. Once you’ve proven that you
can consistently and profitably trade the strategy over a meaningful
period of time (months, not days), then you can begin to ramp up
your position sizing.
Manage
losing streaks.
Make sure that your position
sizing algorithm
helps you to reduce the position size when your account equity is
dropping. You need to have objective and systematic ways to
avoid the “gambler’s fallacy.” The gambler’s fallacy
can be paraphrases like this: after a losing streak, the next bet
has a better chance to be a winner. If that is your belief,
then you will be tempted to increase your position size when you
shouldn’t.
Don’t
meet time-based profit goals by increasing your position size.
All too often, traders approach the end of the month or the
end of the quarter and say, “I promised myself that I would make
“X” dollars by the end of this period. The only way I can
make my goal is to double (or triple, or worse) my position size.
This thought process has led to many huge losses. Stick to
your position sizing plan!
We
hope this information will help guide you toward a mindset of capital
preservation on your journey toward successful trading.
I
have talked to many folks who have blown up their accounts.
I don’t think I have heard one person say that he or she took
small loss after small loss until the account went down to zero.
Without fail, the story of the blown up account involves
inappropriately large position size or huge price moves, and
sometimes a combination of the two.
~D.R.Barton
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