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You may believe that professional traders have a huge advantage over the average “home gamer,” as he likes to refer to viewers of his very popular CNBC show called “Mad Money.” You probably think that professionals have many advantages, such as top-notch research and access to high-level executives at many publicly traded companies. Well, thanks to the Internet, home gamers can now access that same research and thanks to Regulation FD, which requires fair disclosure of all material company information in a public forum such as an SEC filing or a company release. press, such intimate one-on-one meetings are no longer legal, although they probably still happen.
One of the advantages of the professional trader is something that you can easily adopt. It is called Money Management or Risk Management. There’s nothing exciting or sexy about it, but without it you’re just gambling. I always recommend Las Vegas for gambling. The casinos there will at least give you a room, a meal and as many drinks as you can. Vegas makes it fun to gamble and lose. Wall St. won’t give you anything more than a quarterly statement reminding you that the game is down. Money management is the crucial step in calculating risk before entering any new investment or trade. In this article, I will explain how any home player can implement a money management system and start trading like a pro.
First, you need to assess your own risk tolerance. Are you willing to take large losses (greater than 2% of total account size) on any given trade or investment? Maybe you’re only comfortable accepting half of 1% success on any idea. These are unique preferences for each investor. The next step is to set the parameters for the operation. You need to be polite and realistic about both good and bad expectations. The stop price is the parameter you generally set based on analysis of a chart of the stock you are considering for an investment or trade. The price stop could be a support level, a percentage retracement from a recent high, or confirmation of a bearish chart formation. The idea of a price stop is to get you out of a stock before it actually goes against you irretrievably. The price target is another parameter that you set and is typically based on fundamental analysis of the stock to determine fair value or technical analysis that uses charts to predict where the stock might move before momentum subsides.
For example, let’s take a look at a potential investment in Microsoft (Symbol MSFT).
The stock has traded in a $4 range for a year. If you decided to buy MSFT in October 2005 at $25 per share, you can realistically frame your trade using the $4 range. You could set your stop price at $24 per share, as that has proven to be a good support level during 2005. You could set your target at $28 per share, as this has been the highest level for MSFT all year. Now if you enter the rest of your parameters, say 1% for risk tolerance, $100k for total account size into a position size calculator like the one available for free at http://broadbandbrew. com/positionsizing_calc.htm, you’ll quickly see that you can safely buy up to 1000 MSFT shares and still adhere to their risk management system. The Position Sizing Calculator is a calculator that uses the parameters you set to determine the correct number of shares to trade for each investment you are considering, as well as the risk/reward ratio and total profit potential if your position is met. aim. In the MSFT example, the risk/reward is pretty good at 3.0 ($3 up and $1 down). The total profit on the trade is $3,000.00 (not including commissions), which is a 12% profit. That’s not bad for a homegamer.
The Microsoft example is a case in point. Now let’s take a look at another trade, one with very different dynamics. TLT put options expiring in 10 business days. If you decided to buy this option at $0.25 on 11/28 and hold it to expiration, it could very well be worth zero or several dollars. In reality, it was trading at $0.55 just 2 days after your hypothetical purchase. That’s more than a 100% return in 2 days. Are you a genius or just very lucky. It doesn’t matter as long as you manage the risk.
How is this high level of risk managed, you might ask. Exactly the same way we did for the MSFT example. Realistically, you could use zero as your stop loss, as it is unlikely that you will have a chance to stop out due to the extreme volatility. Using the same 1% risk tolerance and $100,000 account size, the Position Size Calculator returns 40 contracts, the maximum number of contracts (trading options on contracts where one contract leverages 100 shares). that you can buy safely and still comply with your risk management system. If you sold the options at $0.55, you made $1,200 (not including commissions), which is a 120% return in two days. Again, that’s not bad for a home gamer.
I mention these very different business examples to clarify this point. By employing a risk management system, you can trade almost anything without fear of depleting your account beyond acceptable levels. Even if you lose, you will survive to trade another day.
I cannot stress enough the importance of risk management. Winning investments always take care of themselves. It’s the losers that cause problems for homegamers. You simply cannot allow one losing trade to affect your entire account to the point where getting back into it requires unrealistic returns.
Interestingly, most amateur investors and traders focus most of their efforts on investment selection and timing of their trades. They spend little or no time managing money. Some always trade a fixed dollar amount, while others use a fixed percentage stop loss, regardless of the varying dynamics of each trade. If you don’t take into account the different characteristics of each investment or trade, you are either taking too much risk or not enough. In the long run, this will hurt your performance.
There are quite a few different position sizing strategies that you can use. Some work better with stocks, while others are more suitable for trading derivatives (options, futures, etc.). All of these are anti-martingale strategies in which your position size increases as your account size grows. For a much more in-depth discussion of money management systems and position sizing, I recommend reading “Trade your way to financial freedom” by Van K. Tharp.
Yes, you can trade stocks and options like a pro. You just need to focus on managing risk the way the professionals do. You should use position sizing models like the one used by this position sizing calculator: http://broadbandbrew.com/positionsizing_calc.htm You should be consistent in applying your own risk tolerance and have realistic parameters for each trade. or investment that you consider.