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Tuesday, December 2, 2008

Traders Toolbox: Money Management - Part 1 of 4

Investors Money Journal

Crucial but often overlooked, money management practices can mean the difference between winning and losing in the markets.

Plenty of books, manuals, and software packages will help you form and opinion of a market, but not many will tell you how to trade once you have decided to get long or short. The goal of money management is to increase the odds of high quality trades. And as we’ll see, leaving the money management variable out of your trading equation can lead to ruin, even if you’re correct about the market direction.

In a broad sense, money management can encompass those elements of trading outside the initial decision to get long or short in a given market or markets – that is, how many positions to put on, when to get out, where to place protective stops. More specifically, it refers to the strategic allocation of capital to limit risk and optimize trading performance in the long run. Allocation of capital can refer to how much money to put into any one market or how much money to risk on any one trade. These decision directly affect how many positions to put on and where to place stop orders.

Given the negative odds inherent in trading (a successful trader can expect to lose money on 60% of his trades), how do you go about maximizing the profit potential of the few winning trades you can expect to have? The answers vary with the disposition and trading style of the individual trader. There exist, however, basic concepts that can be successfully adapted and modified to individual needs, and when the followed in spirit, can boost the promise of long-term trading profits and take some of the stress and uncertainty out of trading.

-Establish A Goal- Having a clear idea of what you want to accomplish by trading, whether it is a short-term profit on a single trade or the desire for a long-term trading career, can go a long way toward building successful trading habits. Regardless of whether or not the goals are set on a per trade, daily or long-term basis, establishing from the outset basic levels of acceptable risk and financial reward will help curtail avoidable risk and extreme losses. Also, determine a specific time frame in which to trade: Will a position have to be liquidated by a certain time for tax purposes or for same other reason?

-Diversification- Just as in the stock market, a portfolio of different instruments can be one of the best hedges against several and unsustainable losses; a loss in one market will hopefully be offset by gains in others. Traders must take caution, though, to truly diversify their portfolios with contracts that are price independent. Spreading your trading among three or four different interest rate contracts that move in a similar fashion is not a good example of diversification, because a loss in one contract is likely to be mirrored by losses in the others. But over-diversification is dangerous, too. A trader can spread his money over too many markets, and not have enough capital in any one of them to weather even small adverse price swings.

A good rule of thumb is to stick with what you are comfortable; do not venture blindly into unknown markets just for the sake of diversification. A balance must be stuck between available resources and a manageable trading scenario. Capital constraints will, of course limit the choices traders can make, forcing those with smaller trading accounts to bypass or minimize diversification. click to Part 2

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