Money Management

No trading system will be successful without adhering to strict money management guidelines. Discipline in trading comes from establishing rules that have proven successful and sticking to them religiously. While most of our work with sound money management stems from our experience with options, stock trading is no less immune to the pitfalls resulting from not following these rules. For the most part, rules that govern options trading apply equally well to stock trading.

The most important guiding principle is to let winners run and to implement strict loss control on all positions. Cutting losses (more on that below) takes on added importance when dealing with shorter trading periods. In addition, you should establish a minimum account size for your stock trading that will provide a satisfactory overall profit given the average size of wins and losses and the overall winning trade percentage that you expect from your trading.

Here are a few other money management principles to keep in mind.

You can be successful with a win rate of less than 50 percent - The principles of money management in stock trading cannot be mastered without a firm grasp of the statistical probabilities involved. In his esteemed book, Trading for a Living, Dr. Alexander Elder sums up the importance of this concept in a word - innumeracy. According to Dr. Elder, "Innumeracy - not knowing the basic notions of probability, chance, and randomness - is a fatal intellectual weakness in traders."

Renowned investing and trading coach Dr. Van K. Tharp addressed the issue of winning percentages in the November 1997 issue of Technically Speaking, the newsletter of the Market Technicians Association. In his article, "Why It's So Difficult for Most People to Make Money in the Market," Dr. Tharp states, "Most of us grew up exposed to an educational system that brainwashes us with the idea that you have to get 94 95% correct to be excellent. And if you can't get at least 70% correct you're a failure. Mistakes are severely punished in the school system by ridicule and poor grades, yet it is only through mistakes that human beings learn.

Contrast that with the real world in which a .300 hitter in baseball gets paid millions. In fact, in the everyday world few people are close to perfect and most of us who do well are probably right less than half the time. Indeed, people have made millions on trading systems with reliabilities around 40%."

The concept of limiting losses and letting the winners run cannot be overstated. In his classic work, The Battle for Investment Survival, Gerald Loeb states, "Accepting losses is the most important single investment device to insure safety of capital. It is also the action that most people know the least about and that they are least liable to execute ... The most important single thing I learned is that accepting losses promptly is the first key to success." In addition, Loeb says, "The difference between the investor who year in and year out procures for himself a final net profit and the one who is usually in the red is not entirely a question of superior selection of stocks or superior timing. Rather, it is also a case of knowing how to capitalize successes and curtail failures."

Losing Streaks Will Occur - An offshoot of this concept that often comes as a surprise to many traders is the experience of coping with an extended losing streak. The ultimate goal of achieving profitability will remain out of reach unless great care is taken to control the amount of capital allocated to each position, as even wildly successful traders are not immune to a string of losing positions.

To shed some mathematical light on the importance of proper money management, our Quantitative Analysis group created the following table that displays the likelihood of experiencing losing streaks of various lengths based on a range of win rates.

The figures in this table are based on a 50-trade period. The "Win Percentage" column encompasses a wide range of potential win rates, from five to 95 percent. The table shows the probabilities of seeing anywhere from two to 11 consecutive losing trades during the 50-trade cycle, based on the corresponding percentage win rate.

For example, with a winning percentage of 55 percent, you stand a better-than-50/50 chance (57.5 percent to be precise) of seeing a losing streak of five consecutive trades. This likelihood increases to nearly 77 percent if you win about half of your trades. The point of this illustration is that you will experience losing streaks. That's the bad news. The good news is that if you stick with your strict money management guidelines, you should be able to weather the storm and eventually enjoy profitable returns.

The moral of the story is that even though losing streaks are part of the game, profitability is achievable if you let winners run and cut losses short, while staying in the game by using proper money management principles.

Positive expectancy - Dr. Tharp has said that a critical factor to winning is "positive expectancy" - over a large number of trades, you should expect to achieve a positive return for each dollar you risk. For example, in the long run an even bet on "heads" in the flip of a true coin yields a "zero" expectancy. This is based on two key facts - the probability of profit is 50 percent and the payoff for "heads" is equal to the loss when "tails" occurs. The formula for this zero expectancy is:

0.50*1 + 0.50*(-1) = 0

A positive expectancy for this bet can occur if the coin was not "true," but instead the probability of "heads" was, say, 60 percent. In this case, the positive expectancy would be 20 cents for each dollar bet, as set forth below:

0.60*1 + 0.40*(-1) = 0.20

Another way to achieve a positive expectancy is for the payoff for a win to exceed the penalty for a loss. If you were paid $1.20 for each head that occurs when a true coin is flipped but you lost only $1.00 when it comes up "tails," your positive expectancy would be 10 cents for each dollar bet as follows:

0.50*1.20 + 0.50*(-1) = 0.10

Let's look at a real-world example. Over a one-year period, one of our stock recommendation services had a winning percentage of 52.9 percent (nine wins and eight losses). The payoff on winning trades averaged 20.2 percent, while the loss on losing trades averaged just 11.3 percent. This yields a positive expectancy of 5.4 cents for each dollar invested as calculated below:

0.529*0.202 + 0.471*(-0.113) = 0.054

In other words, investing in all of the stock trades over this period would have had a slightly more favorable outcome than getting paid $1.10 for each "heads" in a true coin flip while losing just $1.00 for each "tails."

It should now be obvious that a positive expectancy does not require a winning percentage much greater than 50 percent. Rather, it's the interrelationship of the win rate, average win, and average loss that determines overall profitability, or positive expectancy as Tharp defined it.

Allocate an equal percentage of your portfolio to every trade - It is in that same spirit of "staying in the game" that we turn our focus to allocations per trade. In an excellent chapter on money management in New Thinking in Technical Analysis: Trading Models from the Masters (Bloomberg Press, available on www.SchaeffersResearch.com), Courtney Smith discusses how to "play the game long enough to master the skills and information needed to become a profitable trader" using a system he calls the fixed fractional bet. Simply stated, every trade should represent a set percentage of your total account.

One of the primary advantages of the fixed fractional bet system is the principle of convexity - playing more dollars on the way up, while fewer dollars are at risk after each losing trade. On the downside, this system keeps you in the game longer by allowing you to weather the losing streaks that will inevitably occur. On the plus side, your portfolio will increase at a faster rate because you allocate more dollars per trade during winning streaks.

For example, let's say you have $100,000 available for stock trading and you wish to allocate 10 percent of your total account to each trade. You would therefore trade $10,000 for your first trade. Assume the trade gains 20 percent, or a $2,000 profit. Because your account size is now $102,000, your next trade would be for $10,200 (0.1*102,000). Now let's say your first trade lost 10 percent (remember you need to let your winners run and cut your losses short), or $1,000. Your account would now stand at $99,000, meaning that you would allocate only $9,900 to your next trade. Notice how this differs from a fixed-dollar strategy in which you would invest $10,000 in each trade.

Consistency is the key - One other thing we should mention. Don't vary the percentage you allocate trade by trade. Don't double up on a trade after a loss hoping to win your money back right away. There's a technique some blackjack players use in which they double their bet after each loss, the idea being that eventually the cards will turn in their favor and they will be ahead. That's fine (we suppose) if you're betting $10 chips since you likely will have a sufficient bankroll to stay in the game long enough for that to happen. But trading is not so forgiving. Losing streaks will occur, the market may be turbulent and volatile, your system may be flawed, and you might run into a series of trades that will wipe you out. Sure, you may get out of the hole with that one winner, but what if doesn't come in time? If you're sitting on the sidelines with no cash, there's positively no way to benefit from the winners. And as the saying goes, you miss 100 percent of the shots you never take.

The bottom line is that proper money management is the best way to play longer. As Smith states, "…risk management rules are really ways of dealing with the psychology of trading…[which] is the most important aspect of trading…discipline is the key psychological trait that the trader needs to make money. Risk management rules are an effort at trying to enforce the necessary discipline." Maintaining this discipline is the key to ultimate profitability.