The new bride approached her husband on their wedding night and asked for $10 for their first love-making encounter. He was so eager, he agreed, without hesitation. She did this each time they made love for the next 30 years. He gave her the money thinking it was a cute way for her to buy new clothes and get her nails done, and so on. Arriving home one day, she found her husband in a very depressed state. He told her he had lost everything in the market and didnt know what to do, they were ruined. Happily, she handed him a bank book showing deposits and interest for 30 years totaling nearly a million dollars. She then showed him her stock account, which was worth well over another million and told him not to worry, they would be okay. She told him she had invested all that money she had collected over the last 30 years for every time they had sex, and this was the result of her investments.
But instead of a look of glee, he was overcome with disappointment. She asked him, Why the sadness at such good news? and he replied, If I had known what you were doing, I would have given you all of my business!
But he said, I only gave you $10 at a time and even over 30 years it couldnt have been worth more than $30,000 to $50,000. How did you did you do so well? She replied, Do you think everyone is as cheap as you are?
A proper trading plan is made up of two main things. One is the trading strategies that generate the buy and sell signals. And the other is money management. Though it may be more fun playing around making systems, you cannot forget to take into consideration how important the money management part of the plan is. The best systems in the world will not do you any good without a solid money management plan. While on the other hand, a moderate system with a solid money management plan can make you moneyor at least keep you around a lot longer. Money management plans, like systems, should be custom built because people have different risk tolerances. What one person may be comfortable with may give another ulcers. When you do put together a money management plan, make sure it is something that you both feel comfortable with and that will protect your capital. Just having one of these two factors in place can lead to either wide losses or a lack of trading because you are scared to risk anything. You want to be protective of your capital, but you need to take some risk if you want to make money.
DON T TAKE RISK LIGHTLY
I dont believe money management and risk are given a fair shake in trading books. Every now and then youll come across the subject with some extremely advance mathematical theories and formulas that would scare off even a statistics professor. But in general, you dont see nearly as many books on the topic and in most books it only gets a chapter or two. So dont expect this book to be any different I will, however, do my best to give you the material you need to put together a risk plan and then show you how to implement it into your trading plan. Even though you dont see as much written on the topic as it deserves you should not take it lightly as it really is the difference between winning and losing.
In my opinion money management is more important than your trading decisions, and it should be considered first when actually putting a plan together. Your money management will be able to tell you what markets you can trade, how much you can trade, how often you can trade, and how much you can risk. It is the cornerstone of setting stops and tells you if you can actually afford to make a trade or just trade in general. It will help you trade what you can afford and makes sure you are properly capitalized to trade. Though stops should be set based on technical analysis and what the market tells you a good place is, its your money management that will tell you how much you can afford to lose and whether you have the capital to risk what the market can take from you. No matter how good the trade may look, if you risk more than you can afford to lose, you will, at some point, lose it all. Try to remember that keeping your money is actually more important than what you could make.
Dont take it lightly. Most top traders agree that even though they may have different trading strategies, its their money management skills that make them good traders. Its typical to lose money on more then half of your trades. But with a solid money management plan you can easily make money on a 50:50 win to loss ratio trading system or even on a 30:70 system, which is a more typical ratio. If a trader spent the proper time to come up with a great money management system and traded off-the-cuff, he would, in my opinion, do better than a trader who came up with a great trading system and had no money management plan.
ANOTHER GAMBLING ANALOGY
One of the things I find interesting is that when it comes to gambling there is much more on the subject of money management than on actual gambling techniques. For example, the rules of craps or blackjack or roulette can be written on the back of an envelope. You could use the front of the envelope if you want, but for some reason everyone likes to use the back. Its the money management and risk strategies that take up a good chunk of many of the gambling books I read. Like knowing when to double down or split cards in blackjack, or how to take odds in craps. There is also a lot of crap written in some books. There are many so-called gambling systems that tell you to increase your bets when losing or to bet on red after it hasnt come up four times in row. These seem like strategies that will make you money as the odds grow in your favor. But in the long run, they are of no use as each outcome is independent of the previous ones. Yet Ive seen books with such strategies. However, what is valid is knowing how to use your bankroll and what you can afford to risk and when to walk away both winning or losing, and I have seen this as the basis of several gambling books.
Even poker, which is much more a game of skill, has a lot to do with risk analysis. Im not referring to the part that tells you how to manage your money, but to the part that tells when you should make a bet or not depending on the odds. If the odds are in your favor you make the bet, if they are not you dont make it.
T H E M A R T I N G A L E S Y S T E M
The most famous (I think) of these gambling systems I mentioned above is the Martingale System, which tells you to keep doubling your bet after every loss, assuming that you will eventually get it right and win back all your money. The flaw comes in that casino tables have limits on the maximum you can bet, which is usually less then eight times doubling up. For example, doubling up on a $5 bet eight times is $640, but a $5 table has a maximum bet of $500. If you bet using the Martingale System where you double after every loss the progression would look like this:
First bet: You lose $5.
Second bet: You bet $10 and losedown $15 total. Third bet: You bet $20 and losenow down $35. Fourth bet: You bet $40 and losenow down $75. Fifth bet: You bet $80 and losenow down $155. Sixth bet: You bet $160 and losenow down $315. Seventh bet: You bet $320 and losenow down $635. Eighth bet: It would be $640 but the maximum you can bet is $500.
As you can see it would only take eight losses to exceed the table maximum bet. If you havent noticed, it doesnt matter how many times you double up your bet. You will only win five dollars if you eventually hit. If you hit on the fourth bet when betting $40 you will win back the $35 you lost plus $5 more. Yet youve risked $75 so far to win $5; those are not good odds.
Lets say you could exceed the $500 maximum bet. On the eighth bet you are risking $640 to win $5. You have already invested $635 for your previous seven bets. If you lose that one you are out $1,275, but the casino doesnt even give you the chance. They cap your bet at $500 so even if you win you are down $135. Can you imagine risking over $1,000 for a chance to win $5? The casinos know that if someone had unlimited resources they will eventually win. That is why they set maximum bets at the table.
The other flaw in the system comes in that many times you run out money faster then you expect. Say you came to the casino with only $500 on you. You would not be able to make that seventh bet as you would only have $185 left after the first six losing bets so if you did bet all you had and won youd be down $130 anyway.
And there is one other flaw, it does happen that there are times you get a few abnormal streaks every now and then where an outcome will happen 12 to 15 times in row. The casinos love these streaks. Though not often, they do happen and most people cannot afford to keep doubling up so many times. It is also human nature to fade the streak, so people take a beating during them. Casinos love this system as well because when you win, you win $5, but when you lose you lose over $1,000.
Some people who try the Martingale System have some success for a while and swear the system is foolproof. But sooner or later the odds will kick in and they find out the hard way about the flaws in the system. I know because years ago, I thought it was the greatest system in the world until black came up 11 times in row.