Discover the Proven Money Management Plan For Success

There are three vital points to stock market success:

1. Trade in the direction of the trend
2. Use an effective exit strategy
3. Use effective risk management

Strategy 1 and 2 are widely covered in most trading books and articles, so let’s take a look at strategy three in more detail.

Van Tharp in his excellent book “Trade Your Way to Financial Freedom??? addresses the issue of risk management or as he calls it position sizing. It is generally accepted in the trading world that to be successful trading shares your risk management means that the maximum amount of capital you can risk on any trade is 2%.

This means that if you have capital of $50,000 the maximum you should lose on any trade is 2% of $50,000 or $1000, if the trade goes wrong.

What is the best Position Sizing Method?

Van Tharp compares a number of different methods for calculating the position size or parcel size to use. He selects a number of shares and trades $1,000,000 in and out of these stocks over a five-year period. Note all of the different models look at the same trades. The only thing that changes is the amount of money on each trade.

The results are as follows:

• Model 1: Buy 100 shares of every trade Profit: $32,567
• Model 2: Buy 100 shares/$100,000 capital Profit: $237,457
• Model 3: Place 3% of our capital in each trade Profit: $231,121
• Model 4: Risk 1% of our capital in each trade Profit: $1,840,493
• Model 5: Limit losses to 0.5% of volatility (using ATR) Profit: $2,109,266

The difference between these models is dramatic!

A variation of model 3 is what most people would be using to approach the market, placing 10% of their capital into a trade. This will give better results than model 3 but still will not approach the results that are achieved in model 4 or 5.

In this model if we have $50,000 in capital we place $5,000 on each trade. We then limit our loss to 10%, which can be achieved by using a stop loss at 3-7% and allowing for brokerage and slippage. This means that if the trade goes wrong we stand to lose a maximum of 10% of our parcel or $500.

A more advanced strategy is looked at in detail below. This strategy is based on calculating the risk on each trade or Model 4 outlined by Van Tharp above. Here we take into account where we enter the trade and where we will exit if the trade goes wrong.

In order to use this model we plan where we get in to the trade and where to get out if the trade goes wrong. The potential loss is then calculated and the amount of capital we can place on any trade is then worked out. Take our total capital of $50,000 and let us risk 1% of this on any trade. This means that if the trade goes wrong we will lose a maximum of $500.

Let’s have a look at an example trade

Looking at the above chart we will calculate the risk for a trade on ION. Our entry point is $3.01 or higher. Our exit point if the trade goes wrong is at $2.89. Our maximum loss that we will take on this trade is 12 cents plus slippage and brokerage. Let’s allow slippage of 2 cents and brokerage of $100 per trade.

Maximum acceptable loss is $500
Brokerage is $100
Maximum loss between entry and exit is $400
Difference between entry price and exit price, incl. slippage $0.14
Maximum parcel size permitted = 400/0.14 which equals $2857

In this example we can place just under $3000 in the trade and stay within our risk tolerance. If we were to place more than this on the trade then we would be exceeding our acceptable risk. If the parcel size is too small then it may not be worth entering the trade. The minimum parcel size that works in reality is in the region of $3000. Using a parcel size smaller than this could mean that our gains are not significant enough in dollar value to cover our costs of trading.

Tighter stops mean more on the trade with the same risk

Let’s consider that we were prepared to use a tighter exit if the trade goes wrong. Entry point $3.01 exit point $2.99. Slippage and brokerage remain the same as before at 2 cents and $100. This time we will lose a maximum of 4 cents if the trade goes wrong.

Maximum acceptable loss is $500
Brokerage is $100
Maximum loss between entry and exit is $400
Difference between entry price and exit price, incl. slippage $0.04
Parcel size permitted = 400/0.04 which equals $10000

We can now place a parcel of $10,000 onto the trade. A much larger parcel but we are taking the same risk if the trade goes wrong.

Now that we have an understanding of how to calculate and manage our risk the big question is why does this work? Why is this strategy so effective? The reason for this is that we can never be sure upon entering a trade whether it will go well or not.

For the trades that do not work out and we stand to lose more we have less capital committed to them. For the trades that do not work out and we stand to lose a smaller amount we have more capital on them.

Learning to place the maximum on a trade without increasing your risk

This allows us to place a maximum amount onto each trade while fixing our downside. With the equal position size model we do not maximise our parcel size as it remains constant regardless of the risk on a particular trade.

It is important to note that if you follow the 2% rule religiously you could have 100 losing trades and still have some money left. Most traders risk far too much on a trade and many can get caught out in a dramatic move against them.

Following strict risk management rules will improve your results and a little bit of months when you enter a trade could dramatically improve your returns.