Money Management (Pt. I):Controlling Risk and Capturing
By Dave Landry
Money management is the process of
analyzing trades for risk and potential
profits, determining how much risk,
if any, is acceptable and managing a trade
position (if taken) to control risk and maximize profitability.
Many traders pay lip service to money
management while spending the bulk of
their time and energy trying to find the per
fect (read: imaginary) trading system or
entry method. But traders ignore money management at their own peril.
The story of three not-so-wise men
I know of one gentleman who invested
about $5,000 on options on a hot stock.
Each time the stock rose and the options neared expiration, he would pyramid
his position, plowing his profits back in
to more options. His stake continued to
grow so large that he quit his day job.
As he approached the million-dollar mark, I
asked him, “Why don’t you diversify
to protect some of that capital?”
He answered that he was going to keep
pyramiding his money into the same sto
ck options until he reached three to four
million dollars, at which point he would retire and buy a sailboat.
I recently met a second gentleman at a dinner
party. He told me that six months
ago he began day trading hot stocks. It was so
profitable, he said, that he quit a
flourishing law practice to trade full time
. Amazed at his success, I asked him,
“How much do you risk per trade, a half point, one point?” He replied, “Oh no, I
don’t like to take a loss.”
A third gentleman was making his fortune
buying the hottest stock(s) on the
momentum list(s). He, too, was on the
verge of quitting a successful business.
When asked about his exit strategy, he rep
lied “I just wait for them to go up.”
When asked, “What if they go down?” his
reply was, “Oh, they always come
What ever happened to these “trader
s?” Gentleman number one is now
homeless, and the other two are about to
be. They are on the verge of financial
devastation and the emotional devastation t
hat goes along with it. This is the
cold, hard reality of ignoring risk. How do
we avoid following in the footsteps of
these foolhardy traders? Three things w
ill prevent this from happening: 1) money
management, 2) money management, and 3) money management.
The importance of money management
can best be shown through drawdown