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Maintaining good money and risk-management habits is more important than correctly applying technical analysis! Good money-management habits ensure that you’ll survive much longer in the stock market, even with a number of trading failures in a row. Good risk-management habits ensure that the risk-to-reward ratio is in your favor, with at least a ratio of one to three.
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Practicing good money- and risk-management habits helps limit losses in losing trades and helps create profit in winning trades. Let’s assume that you are trading based on daily charts; you would buy a stock and then sell it when the stock drops more than 3% below the buying price. Unfortunately, however, limiting losses is not that easy. In this example, the outcome most likely will be too many losing trades that result in losing all of your money at the end.
How much loss you’re willing to accept will be proportional to how much profit you want to make in a certain period of time. While it’s likely that you’ll only suffer a 2% loss when using hourly charts, your profit target will be in the order of 5%. Using daily charts will result in losses in the range of 10%, but with a profit target in the order of 25%.
Also, do not forget that behind every stock is a company that can go broke! So, you may lose all of your money by investing it in one stock only.
Good Money Management Practices
Good Risk-management Practices
Keep an initial stop based on:
Keep a trailing stop for maximum profit based on:
A first money-management method would be to trade in a limited number of stocks out of an unlimited list of stocks.
A second method, which we will discuss later on, would be to trade a fixed, limited number of stocks.
A $25,000 starting capital could be used to invest in 10 stocks at any moment in time, limiting the capital per stock to $2,500.
Keeping an average loss per stock of 10%, or $250, would only constitute a 1% loss in relation to the total capital.
Of course, you would have to calculate your buying power with each purchase in relation to your cash value and the value of the stocks in the portfolio. You could use the following spread sheet for this:
Calculation of the Maximum Buying Power for a Single Stock |
||
|
|
Available cash |
Total buying power |
25000 |
=RC[-1]-(SUM(R[1]C[-1]:R[10]C[-1])) |
Buying value_1 |
0 |
=RC[-1]-(RC[-1]*0.1) |
Buying value_2 |
0 |
=RC[-1]-(RC[-1]*0.1) |
Buying value_3 |
0 |
=RC[-1]-(RC[-1]*0.1) |
Buying value_4 |
0 |
=RC[-1]-(RC[-1]*0.1) |
Buying value_5 |
0 |
=RC[-1]-(RC[-1]*0.1) |
Buying value_6 |
0 |
=RC[-1]-(RC[-1]*0.1) |
Buying value_7 |
0 |
=RC[-1]-(RC[-1]*0.1) |
Buying value_8 |
0 |
=RC[-1]-(RC[-1]*0.1) |
Buying value_9 |
0 |
=RC[-1]-(RC[-1]*0.1) |
Buying value_10 |
0 |
=RC[-1]-(RC[-1]*0.1) |
|
|
|
Allowed buying value |
|
=IF(R[-12]C<R[-2]C,0, |
|
=SUM(R[-12]C:R[-3]C) |
=SUM(R[-12]C:R[-3]C) |
|
Total investment |
Remainder |
One-hundred percent of the cash value above $25,000 will be available for new investments.
The actual value of the 10 contracts in the portfolio will be reduced by 10% (the average stop value) as an extra precaution when calculating the new contract value.
The maximum buying value for one new contract will then be the available cash and the value of the open contracts divided by 10 (10% of the total capital).
Calculation of the Maximum Buying Power for a Single Stock |
||
|
|
Available cash |
Total buying power |
25000 |
25000 |
Buying value_1 |
0 |
0 |
Buying value_2 |
0 |
0 |
Buying value_3 |
0 |
0 |
Buying value_4 |
0 |
0 |
Buying value_5 |
0 |
0 |
Buying value_6 |
0 |
0 |
Buying value_7 |
0 |
0 |
Buying value_8 |
0 |
0 |
Buying value_9 |
0 |
0 |
Buying value_10 |
0 |
0 |
|
|
|
Allowed buying value |
2500 |
|
|
0 |
0 |
|
Total investment |
Remainder |
We will get the following result with $25,000 starting capital and consecutively buying 10 stocks:
Calculation of the Maximum Buying Power for a Single Stock |
||
|
|
Available cash |
Total buying power |
25000 |
1096 |
Buying value_1 |
2500 |
2250 |
Buying value_2 |
2475 |
2228 |
Buying value_3 |
2450 |
2205 |
Buying value_4 |
2426 |
2183 |
Buying value_5 |
2401 |
2161 |
Buying value_6 |
2377 |
2139 |
Buying value_7 |
2354 |
2119 |
Buying value_8 |
2330 |
2097 |
Buying value_9 |
2307 |
2076 |
Buying value_10 |
2284 |
2056 |
|
|
|
Allowed buying value |
0 |
|
|
23904 |
21514 |
|
Total investment |
Remainder |
As an example, let’s close trades 1 and 4 with a 30% profit, while all of the other contracts remain open. Adding this profit to the capital gives a new allowed buying value of $2,458.
Calculation of the Maximum Buying Power for a Single Stock |
||
|
|
Available cash |
Total buying power |
26477 |
7499 |
Buying value_1 |
0 |
0 |
Buying value_2 |
2475 |
2228 |
Buying value_3 |
2450 |
2205 |
Buying value_4 |
0 |
0 |
Buying value_5 |
2401 |
2161 |
Buying value_6 |
2377 |
2139 |
Buying value_7 |
2354 |
2119 |
Buying value_8 |
2330 |
2097 |
Buying value_9 |
2307 |
2076 |
Buying value_10 |
2284 |
2056 |
|
|
|
Allowed buying value |
2458 |
|
|
18978 |
17080 |
|
Total investment |
Remainder |
You can always see the total invested value and the remaining value when all trades would suffer a 10% loss.
Let’s apply this system and calculate the maximum allowed buying value for each contract. Next, let’s assume the most negative scenario: Each of the 10 contracts ends up as a losing trade with a 10% loss. This happens 10 times in a row for a total of 100 consecutive losing trades
Crash resistant? |
10 contracts investment |
10 contracts losing trades |
Remaining amount |
|
|
|
|
Starting value |
25000 |
|
|
Trade_1 |
23904 |
2390 |
22610 |
Trade_2 |
21618 |
2162 |
20448 |
Trade_3 |
19552 |
1955 |
18493 |
Trade_4 |
17682 |
1768 |
16725 |
Trade_5 |
15994 |
1599 |
15126 |
Trade_6 |
14464 |
1446 |
13680 |
Trade_7 |
13080 |
1308 |
12372 |
Trade_8 |
11830 |
1183 |
11189 |
Trade_9 |
10699 |
1070 |
10119 |
Trade_10 |
9676 |
968 |
9151 |
There still is a remaining capital of $9,151. It looks like good money management; you survive for quite a while, and it’s possible that the following trades will make up for all of the losses!
In the table, you can see the remaining capital after each 10-stock trade.
Money & Risk management next -Part 1 -Part 2 -Part 3 -Part 4 -Part 5 -Part 6
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Risk Disclosure: Futures and forex trading contains substantial risk and is not for every investor. An investor could potentially lose all or more than the initial investment. Risk capital is money that can be lost without jeopardizing ones’ financial security or life style. Only risk capital should be used for trading and only those with sufficient risk capital should consider trading. Past performance is not necessarily indicative of future results.
Hypothetical Performance Disclosure: Hypothetical performance results have many inherent limitations, some of which are described below. no representation is being made that any account will or is likely to achieve profits or losses similar to those shown; in fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk of actual trading. for example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all which can adversely affect trading results.
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