The most important thing that a trader has in his or her arsenal is their trading fund.
Sure, discipline is important … technical know-how is going to help … and a great strategy is a must …
But without money to trade with, you’re really stumped.
And by “money” I don’t mean the last penny in your bank account – I’m talking about the money you’ve set aside to trade with, that you can afford to lose.
Of course, calling it “money you can afford to lose” doesn’t help our mindset. Because, if you want to stay in the trading game, then you can’t afford to lose this money.
Which is why we need to be ultra careful with it.
Getting a great return on my money is important – I don’t know about you, but that’s the reason I started trading in the first place.
But controlling risk has to come top of the list. Yes, it’s great to say that you’ve had some incredible percentage return in a good year, but it’s even better to be able to say that you’ve managed to hold on to the bulk of your trading fund through a rough year.
Running a business
You don’t have to have run your own business to know that having a good product or service to sell is only a fraction of the story.
Just last year, the pub down the road from where I live had a bustling, award-winning restaurant, and was regularly packed out on a weeknight. Then the landlords put up the rent, and within 2 months the business had gone under.
The food was good. The beer was good. But they weren’t making enough of a margin to keep the business afloat.
It just goes to remind us that no matter how great our strategy is … and how great our technical knowledge is … it won’t be enough to be profitable if we can’t manage the money side successfully.
Finding the sweet spot
When it comes to risk, there’s a balancing act to be struck.
Take too much risk, and you increase the chances that you’ll go bust.
Take too little risk and you can’t make enough return to cover your transaction costs, and to justify the time and effort you’re spending.
That said – be careful not to over-value your time here – time spent learning the ropes and getting a feel for trading, while holding on to your fund (not growing it, just standing still), can still be time valuably spent.
In our search for the “sweet spot” between these two extremes, it’s a good idea to be always thinking: capital preservation. If you get it wrong and you’re risking too little, then you can always correct up. But if you get it wrong and risk too much – you may well not have a second chance to get it right.
Taking your temperature
The rule of thumb used by most short-term traders is the 2% rule. This states that you should never risk more than 2 per cent of your pot on any one trade.
That way, if you hit a losing run, those losses shouldn’t hurt too much.
And all trading strategies will have losses along the way – it’s part of the process. And those losses do have a nasty habit of coming together, in losing runs. So one of the most important things to be prepared for is one of these losing runs, so that you’re not set back too far when they happen.
Of course, the 2% rule doesn’t really address the issue of “portfolio heat”. This “heat” is the amount of your money at risk at any one time.
If you’re risking 2% per trade, with 5 trades, then your portfolio heat is 10%. If you’re risking 1% with 8 open trades, then your heat is 8%.
So, it’s all well and good to say that you have great money management, only risking 2% on any one trade, but if you’re sitting on 15 open trades, then you’re risking 30% of your portfolio – right now.
And, unless those trades are carefully hedging each other, if something unexpected happens in the markets, like a piece of news sending things violently in one direction or another – you run the risk of having all your stops hit in one fell swoop.
Sound unlikely?
Well, these sudden market moves really aren’t that uncommon – and with the current economic conditions, they seem to be happening more often than ever before.
I can’t give you an optimum level of heat for a trading portfolio – it depends so much on the volatility of the markets you’re in … whether your trades are hedged … the size of your portfolio … and your personal risk appetite.
But if you find that you’re being tossed and jostled by the market more than you are comfortable with – then you should be looking at your risk and heat levels – perhaps they need to be turned down.
