V. Money Management
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No literature on technical analysis would be complete, if there is no mention of some type of money management technique. Some traders believe that money management is the most important ingredient in a trading program, even more crucial than the trading approach itself. I'm not sure I'd go that far, but I don't think its possible to survive for long without it. Money management covers the allocation of funds. It includes such areas as portfolio makeup, diversification, how much money to invest or risk in any one market, the use of stops, reward-to-risk ratios, what to do after periods of success or adversity, and whether to trade conservatively or aggressively.
Admittedly, the question of portfolio management can get very complicated, requiring the use of advanced statistical measures. The following are some general guidelines that can be helpful in allocating one's funds and in determining the size of one's trading commitments:
1. Total invested funds should be limited to 50% of total capital.
2. Total commitment in any one sector should be limited to 10-15% of total equity.
3. The total amount risked in any one stock should be limited to 5% of total equity.
These guidelines are fairly standard in the industry, but can be modified to the trader's needs. Some traders are more aggressive than others and take bigger positions. Others are more conservative. The important consideration is that some form of diversification be employed that allows for preservation of capital and some measure of protection during losing periods.
Using Protective Stops
I strongly recommend the use of protective stops. Stop placement, however, is an art. The trader must combine technical factors on the price chart with money management considerations. The trader must consider the volatility of the market. The more volatile the market is, the more loose the stop that must be employed. Here, a tradeoff exists. The trader wants the protective stop to be close enough so that losing trades are as small as possible. Protective stops placed too close, however, may result in unwanted liquidation on short term market swings (or 'noise'). Protective stops placed too far away may avoid the noise factor, but will result in larger losses. The trick is to find the right middle ground.
Reward to Risk Ratios
The best traders make money on only 40% of their trades. That's right. Most trades wind up being losers. How then do traders make money if they're wrong most of the time? Since markets can be quite chaotic at times, even a slight move in the wrong direction results in forced liquidation. Therefore, it may be necessary for a trader to probe a market several times before catching the move he or she is looking for. Because most traders are losers, the only way to come out ahead is to ensure that the dollar amount of winning trades is greater than that of the losing trades. To accomplish this, most traders use a reward-to-risk ratio. For each potential trade, a profit objective is determined. The profit objective (the reward) is then balanced against the potential loss if the trade goes wrong (the risk). A commonly used yardstick is a 3 to 1 reward-to-risk. The profit potential must be at least three times the possible loss if a trade is to be considered.