Last weekend I wrote about some of the difficulties encountered
when a trader begins the transition from paper trading to trading with
real money. This article looks at the specific subject of money which
may be the root of all evil, but is certainly the element that
introduces the dangers of emotion when we leave the relative safety of
paper trading and put our cash at risk.
The first and most important rule of trading real money is to use
only "risk money." Risk money is money that you can afford to lose. It
would not make you happy if you did lose it, but your life would go on
without any change. In other words, risk money is money that is not
needed for any necessity. As we transition from paper trading to real
money trading, we must not use the rent money, mortgage money, grocery
money, car payment money, insurance premium money, or tuition money. If
that is all we have, it is not yet time to trade real money. Using
money to trade that is needed for some necessity is dangerous and can
cloud judgment. It places undue pressure on us. Lee Trevino, the
famous golfer, once said something like: "Pressure is standing over a
$50 putt with only $5 in your pocket."
As we begin trading, we must understand it is a business;
successful traders rarely are gamblers. They do everything they can to
put the odds in their favor. In addition to using only risk money, they
carefully manage the money they are trading. One way to manage money
for the beginning trader with a small account is to make equal dollar
trades. If the trader is starting with $5,000 for example, each trade
might be $500 or $250. What we don't want to do is make one trade
$2,500 and the next $250. How could we possibly know which one is going
to be successful? Generally, Murphy's Law goes into operation and we
have a big loss on the $2,500 trade and a small gain on the $250 trade.
Trading in that fashion soon takes the trader out of the game. Our
first objective is to stay in the game. Making equal dollar trades
helps us do that. Even if we lost all the money risked on one trade it
would not be the end of the world. Of course, if we have a good exit
plan, it would be unlikely that we could lose everything invested on the
trade. On the other hand, if we placed a large portion of our money at
risk on a single trade, it could end our career.
I once had a student who began trading real money and was doing
quite well. He was making equal dollar trades and had six or seven
winners in a row. He was calling me every day and telling me how well
he was doing. "Bill," he would say, "I made $700 today." Or, "I just
made $550" and so on. One day, the phone didn't ring. I did not hear
from him for several days so I finally called and asked how he was
doing. He told me he no longer was trading. When I asked why, he
responded that after all the successes in a row he thought he had
figured out what the stock he was playing was doing. He put ALL his
money on a bullish play and the next morning the company issued some bad
news, an analyst downgraded it and the stock gapped down several
dollars. He had bought out of the money calls and was literally wiped
out. He has never traded again.
That sad story is all about money management and greed. If we
manage our money properly, we remove a large part of the risk and
prevent our greed from enticing us to do what the fellow in my example
did. As we begin to trade real money, we are still building our
confidence. Our paper trading may have been very successful, but it
just isn't the same. Now, something important is on the line. Take it
easy. Build confidence with equal dollar trades. If you lose part of
your money on a small trade, so what? You will have losing trades so
keep the losses small.
I believe an even better way to manage trading money is to use equal
percentage trades rather than equal dollar trades. That is difficult to
do with a small account, but can definitely be utilized as your account
grows. I personally favor making trades where only 3% to 5% of risk
money is placed at risk in any given trade. When losses are incurred and
the account value drops, the next trade automatically is made for a
lesser amount and when gains are made, greater amounts automatically are
invested.
This seemingly simple device of managing money can build confidence,
protect assets, and enable the trader to stay in the game. When tempted
to "put it all on black" please remember my friend's story.
Good Trading!
Bill Kraft
Mr. Kraft's past articles are posted on our website for your review.
