Money Guidelines

Let’s start by going through some general guidelines that have worked over the years. After you get some experience, if you think you know better you can do something else, but these guidelines are designed to keep you out of trouble and in the trading game, so you ignore them at your peril.

  1. Limit your commitment to any one stock or financial instrument to only 10% of your trading account. If you have $50,000 in your account only consider putting $5,000 towards any particular trade. This applies regardless of how good you think the opportunity may be.
  2. Limit your commitment to any market sector to a maximum of 25% of your trading account, or $12,500 for the example above. Securities in any particular sector tend to move in tandem, so you don’t want to have too much of your account riding on any particular group.
  3. Limit your possible loss on any one trade to 2% of your trading account. While this may sound very low, bear in mind that this is the possible loss, and not the amount you put into the trade. Some professional traders even think 2% is too much.
  4. If you are trading in a financial instrument that may result in a margin call, such as futures, plan to use a maximum of 50% of your trading account in active trades so that you have an adequate reserve on which to fall back if things don’t work out.

When you are looking at the above figures, you should always calculate the percentage of your actual current trading account, and not the amount you started with.

You may be wondering why the numbers given above seem so conservative. The simple answer is that you need capital to trade, and if you’re not always preserving your capital then you may find your trading career abruptly finished. While you may not want to think about it, sometimes you may find that you have five or six losing positions in a row and you want to be able to survive. If your possible loss is 10%, not 2%, then you will have lost half your trading capital. This requires you to profit by 100%, or double your money, just to get back where you started from. Professional money managers, even hedge fund managers, will usually take the same low percentages.

Diversification

Diversification is much vaunted as a recipe for avoiding catastrophic losses, on the principle expressed in 2 above, that similar securities will tend to move together. For instance, there is little point in owning a dozen oil companies. If the price of crude oil goes down sharply due to say, an unexpected recession your portfolio will take a hit. There is a trade-off to be had — if you spread yourself too thinly around many different markets then you may find it hard to keep track or to assess the way each market performs. You need to strike a balance. In technical terms, you are more diversified when there is a negative correlation between the different markets that you trade.

One example is that when the dollar is weak, gold tends to be stronger as investors prefer to move their money over to the perceived security of the physical metal. The opposite example would be holding three Forex trades that were long on the dollar in different currencies. Having different currencies does not diversify your position, as any weakness in the dollar would be reflected in them all.

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