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MONEY
MANAGEMENT
by Brandon Fredrickson
Here are some quotes
from some great traders and investors:
•"I
haven't met a rich technician" - Jim Rogers.
• "I always laugh at people who say "I've never met a rich technician"
I love that! It's such an arrogant, nonsensical response. I used
fundamentals for 9 years and got rich as a technician" - Mary
Schwartz.
• "Diversify your investments" - John Templeton.
• "Don't bottom fish" - Peter
Lynch.
• "Don't try to buy at the bottom or sell at the top" - Bernard Baruch
• "Maybe the trend is your friend for a few minutes in Chicago, but for
the most part it is rarely a way to get rich" - Jim Rogers.
• "I believe the very best money is made at the market turns. Everyone
says you get killed trying to pick tops and bottoms and you make all
your money by playing the trend in the middle. Well for twelve years I
have been missing the meat in the middle but I have made a lot of money
at tops and bottoms." - Paul Tudor Jones.
So here we have a group of guys who have collectively taken billions of
dollars out of the market and they don't agree on a damn thing
regarding how to make money. Not one. So what is a person to do? Is
there anything they do agree on? Just one:
• "My basic advise is don't lose money" - Jim Rogers.
• "I'm more concerned about controlling the downside. Learn to take the
losses. The most important thing about making money is not to let your
losses get out of hand." - Marty Schwartz.
• "I'm always thinking about losing money as opposed to making money.
Don't focus on making money, focus on protecting what you have" - Paul
Tudor Jones.
• "Rule number one of investing is never lose money. Rule number two is
never forget rule number 1" - Warren Buffet.
There really are a lot of ways to make money in the market. There are
tons of seminars you can pay for that will tell you "How I made $1
katrillion dollars in the stock market" and its sister book "How I
Double my Money Every Hour" is available in many different forms too
for only $29.95. All of these will tell you some patterns that will
work sometimes and won't others. Some might have you going long with
Jimmy Rogers, while others will have you doing it with Bernard Baruch,
but when it gets right down to it the most critical part of making
money, is not losing much. Your always going to take stops and lose
some. But you don't want to lose much, because you won't make a penny
tomorrow if you go broke today.
One of the most common mistakes traders will make is that of "risking
the whole wad". There is not a faster way to have bad things happen to
you than to do this. Studies have been done that suggest the most you
should risk on any one trade is 2%. And most pros will tell you that is
way too much and they risk 1/4 % to 1% on each trade. The idea here is
that no one trades is going to really effect you either way. You're not
going to get rich, but your also not going to have to sell the house,
as has happened to people.
One other benefit of small positions is that it allows you some freedom
from worry. If you are risking a fairly small amount, your not going to
get shaken out. You're also not going to find yourself in a position
where you say "Sheesh, I can't lose this much money" and you turn bad
trade into a terrible investment. So, if you are serious about this, if
you want to make it long term you will practice sound money control.
Before you ever enter a trade, the first thing you should ask yourself
is how much am I risking here because, remember that while we are here
to make money, we won't make any if we go broke.
The key to not going broke is to respect risk, take small positions
that wont allow you to blow out. You must always keep in mind that in
trading you are only playing the odds. You may have a setup that is
correct 75% of the time but each trade is a random event. It doesn't
take into account the last trade. If you have a 75% system, you can
still be wrong 10 times in a row, and if you trade for any amount of
time it will happen.
I once thought I had a foolproof way to make money at roulette. I would
bet on black and red. I would sit at the table, and after the ball had
landed on black or red 5 times in a row I would start to bet on the
opposite color (so if it were 5 reds in a row I would start to bet on
black) Then, if I was wrong, I would go ahead and double down, meaning
that if my starting bet is $1, the next time I will be $2, then $4,
then $8, then $16 etc.. Eventually I would win, and would come out $1
ahead. So I am 13 years old and really thinking I have the Holy Grail.
If its so easy for a 13 year old to figure out, why is it that all the
casinos are not out of business and we are all millionaires Simple. It
does not work.
If we are flipping coins heads has a 50% chance of turning up on each
roll, and so does tails. But each flip is independent of the last. The
last coin toss has nothing to do with the one before it. It's a random
event. There is a certain chance heads will occur on this roll, or that
tails will. But which of them it is that comes up is a random
occurrence. Each time you flip a coin it is one flip of a coin amongst
the billions of times coins have been flipped. That's why you can roll
100 heads in a row if you do it long enough. That's why the first time
I played roulette black came up 19 times in a row and I went home
defeated.
Trading is the same. We have a certain percentage of our trades that
will work out, and a certain percentage that will not. But your next
trade has nothing to do with your last one. So even if you have the
world's most accurate method, over time you will go broke if you don't
practice good money management and risk control.
So now that we all understand why money management and risk control are
very important lets cover exactly how to apply these rules to your
trading. As I stated before, you shouldn't ever risk more than 2% of
your account on one trade. But, as I also said, that's a bit much for
most people and I'm in that group of most people. I like to keep my
risk to around 1%. So lets focus our attention on risking 1% of your
account on a trade. For the sake of this example let's just assume you
have a very average account size, $25,000:
Say you are scanning tonight and come across XYZ which looks like it
might be a great swingtrade buy if it trades at 15 3/16. The low of the
prior day is 14 1/2. This means you will place your stop at 14 7/16,
risking 3/4 of a point on this trade. Assuming a $25,000 trading
account you can lose up to $250 per trade. You will use this number to
determine how many shares you can buy, which in this case is up to, but
not more than 333. Most people don't like to do odd lots, so would
round down to 300. Never round up because then you throw the risk
control out the window.
Let me leave you with a few more quotes on risk control:
• "If you have an approach that makes money, then money management can
make the difference between success and failure... ... I try to be
conservative in my risk management. I want to make sure I'll be around
to play tomorrow. Risk control is essential." - Monroe Trout
• "If you personalize losses, you can't trade." - Bruce Kovner
• "The best traders have no ego. You have to swallow your pride and get
out of the losses." - Tom Baldwin
• "Never risk more than 1% of your total equity in any one trade. By
risking 1%, I am indifferent to any individual trade. Keeping your risk
small and constant is absolutely critical." Larry Hite.
While all of these guys have different methods for making money, each
of them agrees that risk control is the single most important aspect of
trading. These individuals are the best in the world and the only thing
they agree on is risk control. Think about it...
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