Today I would like to share my thoughts on the 3rd M or money management, though, this is not necessary for small traders. However it is important enough for it accounts for why most traders get blown out of the market. It is the confidence booster to your trading plan that allows you to trade without fear, calmly and with peace of mind.
Most traders have no idea of position sizing and hence over-trade and too much money is spent on paying commissions. This whittles down the capital, diminishes the profitability, survival of the trading account and hence misses the opportunities when the crucial big trade comes. They trade by buying 1 lot, the default or whatever they feel is right. And never changing the lot size when the trading account size is increased or decreased.
Position size is important for it ensures long term survival and buy time to reflect, analyze and improve one’s trading plan towards profitability. It allows you to trade without fear as you are trading within your level of risk and a chance observe your own trading behavior. It answers the question of how much money is put to the trade each time.
How does one set the size of trade? Basically it can be one of the following
a) Your acceptable capital loss divided over day’s volatility, e.g. one decides it is based on say 3% of capital available, of $100,000. Then if that stock shows a daily range of $1, the number of shares to buy is $3000/$1=3000 shares
b) Your acceptable capital loss divided over % loss in stock price, e.g. if the stock price is $10, and you can accept a loss of say 10% = $1, then $3000/ $1= 3000 shares to buy
c) Trading capital divided into number of multiples. E.g. $50000 trading account divided into 10 units ($5000) and hence if price is $2.50, proceed to buy $5000/$2.50 and hence buy only 2000 shares
d) Dollar invested per fixed amount of capital, e.g. $1000 to buy stocks for each $10000 available in trading account. Hence if capital is $50000, buy number of stocks worth $5000 each time
Note that most successful traders learnt to vary their trading size using an anti-martingale system i.e. increase bets when winning and reducing when losing.
Whatever it is, but decide your position size method for that’s the first sign of self-confidence in your trading plan and stick to it. The “stick to it” is the paramount rule that enables a trader to dare lose the fight and survive another day. Otherwise he loses uncontrollably and never come back again.
Hence this is why position size is very important for it must be consistent with your personal beliefs as to what is your preferred level of risk. When you are comfortable here, no one can take away the feeling that you are ready for trading anytime, any market conditions and any day. You know your maximum loss and you will never be dead in the water and blown off the market anymore. All that follows is how you can take the time to make fine-tuning to your trading system to apply the methodology of stock selection and the rules that make for profit enhancement.
Happy Kaizen Trading!