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Risk Control and Money Management PDF
Risk Control and Money Management PDF
M
where the size of the order is specified. head (quote feeds, electricity, rent, sub-
The essence of risk management is mak - scription to Active Trader magazine, etc.)
ing a logical decision about how much to and trading will be a losing proposition.
oney management is like buy or sell when you fill in this blank. Risk more and the returns will increase,
sex: Everyone does it, This decision determines the risk of but note that the potential drawdown
one way or another, but the trade. Accept too much risk and you (account losses you will need to endure to
not many like to talk increase the odds that you will go bust; get the return — another cost of doing
about it and some do it better than oth- take too little risk and you will not be business) always increases as you increase
ers. But there’s a big difference: Sex sites rewarded in sufficient quantity to beat the per-trade risk. Returns continue to
on the Web proliferate, while sites devot- the transaction costs and the overhead of increase moving into the overtrading
ed to the art and science of money man- your efforts. Good money management zone. Trading at the peak of the potential
agement are somewhat difficult to find. practice is about finding the sweet spot return curve is very difficult psychologi-
There are many, many financial sites between these undesirable extremes. cally because the per-trade drawdowns
on the Web that let you track a portfolio
of stocks on a glorified watch list. You FIGURE 1 RISK vs. REWARD AND DRAWDOWN CURVE
enter in your open positions and you get Proper money management is a function of finding the point that maximizes
a snapshot, or better yet a live, real-time return within acceptable risk parameters.
update, of the status of your stocks 70
based on the site’s most recently avail-
Sweet spot 60
able prices. Some sites, like Fidelity’s,
provide tools that tell you how your Overtrading 50
portfolio is allocated among various Undertrading 40
asset classes such as stocks, mutual Drawdown
30
funds, bonds and cash.
While such sites get at the idea of 20
money or portfolio management, the 10
overwhelming majority fail to provide
0
the tools required to answer the central
question of money management: “When -10
I make a trade, how much do I trade?” -20
(Try and find the topic of money man- -30
agement on the Motley Fool site.)
We’ll discuss how to measure and -40
manage trade risk and where to find the 1 2 3 4 5 6 7 8 9 10 11 12 13
tools to help do it in a responsible and Risk taken
profitable manner. The key underlying
can be extremely high, and the margin of speculative, maniacal extended leg of The investor’s game seems to consist
safety for dealing with unexpectedly high the bull market fueled by the dot.com of selective hitchhiking on a freeway
losing trades is very low. In other words, land rush since 1997. This type of market that is only going in one direction with
you’re getting into territory where one — where making money consists of tak- the object of getting a ride from the
huge loser can blow you out. ing a ride on the back of the bull trend Mercedes driving in the fast lane. They
The best place to live on this curve is and buying the dips — tends to turn the don’t know how far the car is going to go
the spot where you can deal with the merely bold (and possibly reckless) into and they don’t really know when to bail
emotional aspect of equity drawdown market geniuses. The perceived risk in out when the car starts driving in
required to get the maximum return. stock market investing has been very reverse.
How much heat can you stand? Money low, so the need to manage that risk has They are slow to switch cars when one
management is a thermostat — a control not been a pressing concern. Why worry hits the breaks, runs out of gas or blows
system for risk that keeps your trading when it will always come back and you a head gasket. There is a great amount of
within the comfort zone. can make a killing if you buy more? hope and faith involved.
More important to success than man- Many of these active investors don’t
aging risk was the ability to charm your pay attention because they operate
It’s surprising that even many active broker into getting you into the latest under the assumption, reinforced by a
traders and investors have no idea what IPO allocation. 20-year old bull, that the market eventu -
money management is about. They gen- ally will go up again and the safe thing
erally entertain a fuzzy notion that it has to do is hold on or, smarter yet, buy
to do with setting stops, and that disci- There are really two types of people more to lower the cost basis on the posi-
pline is involved to make sure you exe- operating in the financial markets: tion. In this game it doesn’t matter very
cute the stops when they are hit, but traders and investors. It is useful to much whether the car has good brakes
A
TABLE 1 SOFTWARE SITES — SIZING THINGS UP
few Web sites provide soft-
ware or Web-based tools for
understanding money man- Software Type Risk Mgmt? Company
agement. Most of the large Athena Money Software Yes International Institute
finance sites do a fair job at letting you Management of Trading Mastery, Inc.
track the value of your investments, Fund Manager Software No Beily Software
but none of them are really suited for
tracking the performance of a trading kNOW Software Web site Yes
program — for that you need a piece of
software. Money Maximizer Software Yes Trading Research Design
The popular finance software pack-
Stocktick Webware No NAC Consulting
ages, such as Quicken and Microsoft
Money, can track the history of your StockVue 2000 Webware No NQL Solution
transactions but don’t do as good a job
at treating these as trades. They’re QCharts Software Yes Lycos/Quote.com
fine for showing you the value of your
portfolio, and can save you time
Trade Tracker Excel Yes TraderCraft Company
preparing your tax return, but they are
not suited to executing the steps out- Medved Quote Tracker Webware No 2GK Inc.
lined in the main story. Money 2000 Software No Microsoft
Table 1 (right) is a list of sites and
software packages that help with these Quicken Software No Intuit
tasks, some better than others. Money Captool Software No Captools Company
Maximizer, software written by traders Portfolio Web site No Quote.com
for traders, is a good package for man-
aging your trading risk by sizing your TradeFactory.com Web site Yes TradeFactory.com
trades to the amount of risk you want Money Web site No Microsoft Investor
continued on p. 66