Option Investor
Educational Article

Money Management

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By Lynda Schuepp

I'd like to thank the readers for the feedback last week. It is difficult to gauge my writing to the "average" reader. One reader wrote, "Congratulations on what I consider an excellent article on the butterfly spread. I'm sure I have read articles on this and other spreads many times on OI but they just seemed too complicated..." Another reader wrote that my descriptions were so difficult to understand that they were thinking of canceling OIN. This tells me we have a very wide range of reader experience, which makes my job quite difficult. It's like sticking your head in the oven and your feet in a bucket of ice water and concluding that you are comfortable "on average." From the extremes in the comments, I am going to try to write a very basic article one week and a more advanced article the next week. Trouble is you're going to have to read the article to determine which one it is. Who knows you might pick up something, even if it is basic and you also might pick up something if it is more complicated. Now that we've cleared the decks, onto the topic - money management.

This is a subject that should be near and dear to your hearts if you've been trading for the last year. Last week I touched on the subject with regard to risk versus reward, and this week I'd like to share some additional ideas that could help your decision-making going forward.

Many of us, myself included, look at a chart and want to jump in, not really knowing our risk to reward, as discussed last week. However, I'd like to share a new twist that might prevent you from getting into more risky trades.

First, you need to determine an average amount you are willing to risk with each trade. William O'Neil of Investor's Business Daily recommends no more than 8% per trade, which is a good place to start. Let's assume you are starting with $40,000 to trade with - then no trade should exceed $3200. This allows you to have about 12 positions at any one time, although, I for one have a hard time managing that many.

Next, you need to go back and look at the last 10 trades. Add up the total profit and divide by the number of trades, that will give you your average profit per trade. Now go back to the last 10 trades and do the same with your losses. Finally, divide your average profit by your average loss. Hopefully, this number will be greater than 1 (which means you made money). If not, then you need to seriously evaluate those last 10 trades and change the way you are trading. Are your stops tight enough and do you let your profits run, or do you let your losses run and sell too soon on the profit side after having a string of losses? Go back and study each chart and your point of entry, was it a good place to enter, what were the signals, did you know when earnings were due, or did you enter after a CEO lunch on CNBC? You will learn a lot about yourself if you go back and really spend some time on each trade.

Let's create a reasonable scenario of a profitable trader: 10 trades with 4 winners, and 6 losers.

You probably will be winning less times but with bigger wins and losing more times with a smaller amount of money with each loss.

Trade 1 +6400
Trade 2 -3000
Trade 3 -2400
Trade 4 -4000
Trade 5 +9600
Trade 6 -3800
Trade 7 +3200
Trade 8 -2000
Trade 9 -1600
Trade 10 +3200

In this scenario, there were 4 profitable trades with profits totaling $22,400, for an average win of $5600 per trade on an investment of $3,200 per trade and 6 losing trades with losses totaling $16,800 for an average of $2,800 per loss. The average win was $5600 was calculated by dividing the total win money by 4 and the total losses by 6. This is a reasonable scenario for a short-term trader.

Next, we calculate our risk to reward history, average win, divided by average loss which in this scenario would be $5,600 by $2,800 or 2 to 1. To interpret how to use this information, you simply need to find trades that have the potential to deliver 2 times the win versus the potential loss, which would be your stop. Some traders simply blindly put on stops and say, if I lose $1000 on the trade, I'm out. Stops should be well thought out and should have some strong technical basis such as below strong support, break of an upward trendline or cross of some moving average or a Fibonacci retracement (topic of a later article). The projection of how high the stock can go should also be based on technical analysis such as a previous area of resistance, an earlier gap, a nice round number like 100 or some other such trigger.

Now let's look at a stock and see whether a particular trade that we would like to make, fits our profile.

Daily chart of ADM up to February 14th:

Looking at the chart above with only a couple of signals that can be used to enter trades, ADM closed below the 5 and 10-day moving averages and there is a divergence between the moving average oscillator and prices. Let's say we wanted to short here at $15.13, we could either short the stock or buy March puts with a strike price of 15, allocating no more than $3200 in the trade as outlined above. Now let's calculate whether this trade fits the profile we defined above. My stop would be placed at the high of February 8th ($16) and my target would be the low of January 22nd ($13.38). Let's assume we shorted the stock (because I don't have option prices going back to create the scenario), the risk would be 7/8 of a point if the stock reversed and I got stopped out at $16. My potential reward would be reached if the stock continued down to test the previous low at $13.88, which would be $1.75 gain. Reward to risk is 2 to 1, which meets the criteria. This looks like it would make a nice trade with minimal risk. Do 10 of these, win on 4 and lose on 6 with similar profiles and you consistently make money. Don't be afraid to walk away from a trade that doesn't fit your criteria, no matter how good you "think" it might be. Traders who have been around for a long time will all tell you the say thing, money management is key to longevity in the market.


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