THE MAIN GOAL IS TO START NOW!

My goal is to get you started sooner rather than later with a system that is workable, so that you can immediately benefit from the value of managing your risk. If you don’t have any system in place right now, then this is the perfect time to get it right. And, if there are a few areas in your current system that need attention to get you to the next level, let’s work on that.

It’s been my observation for many years in working with traders and investors all over the world that risk control tends to be the last piece of the puzzle that most people focus on. Usually, trading entry strategies, software, and systems win first place in the popularity contest—maybe because the belief is that the “system” will generate great fortunes.

Ultimately, a system alone won’t create great riches. In addition to the system, traders and investors need to develop discipline and a strong financial psychology, and they must be working with true risk capital—money they can afford to lose. Plus, they need a sound money management system to maximize their system profits and keep them out of financial danger.

EXPECT THE UNEXPECTED

There is a world of risk out there, and managing it is a lifetime endeavor. Every time you get in the car, you risk the possibility of having an automobile accident. When you walk in a thunderstorm, you risk getting hit by lightning (a remote risk, but a risk nonetheless). You may face certain medical risks (which vary, depending on genetic and family history) or risk of losing your job—the list can go on and on.

Typically, in our society, we attempt to control or manage these risks by obtaining insurance, or by using greater care in our day-to-day behavior and choices. For example, you may very well currently have an insurance policy that protects you from auto theft, collision, and bodily injury. You might have medical, life, homeowners, or unemployment insurance. And if you are really responsible, you probably exercise, eat right, and look both ways before you cross the street.

All these precautions and procedures are designed to reduce, not eliminate, the possibility of being devastated by a variety of unexpected circumstances. And that is just the point: These circumstances are unexpected. Our job as traders is to make a habit of expecting and being prepared for the unexpected.

In addition, we need to avoid a state of “trader paralysis” that can be created by unexpected events. If we are well prepared we are better equipped to combat the fear that trading can trigger.

SIX TYPES OF RISK TO MANAGE IN TRADING

In the spirit of expecting the unexpected, we can always attempt to plan for what might happen. In doing so, there are half a dozen primary types of risk for you to consider every time you place a trade. We will cover each of these in detail in the coming chapters, but ponder the following top six for now:

1. Trade risk

2. Market risk

3. Margin risk

4. Liquidity risk

5. Overnight risk

6. Volatility risk

THE LAYOUT OF THIS BOOK

This book is laid out in five parts, all designed to help you develop your own money management system. Following is a summary of the parts so you will have an understanding of where to get what you need at any given point along the way. Make the book work for you. Refer to the table of contents if you want to dive in to one specific topic, you can fluidly move from one part of the material to the other, depending on your experience level and needs.

Part One: Psychology of Risk Control

The mind is a powerful piece of the puzzle in our quest for financial success. There are times when we can be our own worst enemy. Missed opportunities, poor choices, and angry rebellion at the market can all create disaster.

And it is working on the underlying psychology that drives our trading and investing choices that can be the magic key that helps us break through stagnant or nonexistent profits. Here you will see what issues to look for and how to address them in order to more effectively implement your money management system.

Part Two: Stop-Loss Exits

If I had a nickel for every time a trader e-mailed me about losing large sums of money and not having a stop-loss exit in place—well, I’d have a lot of nickels! In any event, sometimes it isn’t that an individual doesn’t know they need a stop-loss exit in place; instead it’s that they don’t know how to effectively choose one. Or, they choose one and then don’t adhere to it for psychological reasons (see Part One).

In Part Two, we’ll clearly take you through a variety of stop-loss approaches and give you tips on how to make sure you do adhere to them when they are hit.

Part Three: Trade Size Does Matter

Are you trading the same exact number of shares on every trade every time, without examining the current market dynamics? It is neat and tidy to have a nice round number of shares or contracts (100 or 1000), but it might not be in your best interest to do so. The concern is that you may be taking on too much risk for certain market conditions.

In this section, you’ll learn how to determine how large (or small) your trade size should be so that you are not overextending your risk. You’ll even be able to download the Trade Size Calculator™ software (a one-month trial is included in your purchase of this book) to see how easy and fast it is to calculate the best trade size for each trade.

Part Four: Record Keeping and Profit/Loss Analysis

Record keeping may not be your favorite pastime, but it is crucial and will pay you significant dividends down the road. If you truly detest the practice of tallying up your profits and losses, that may be a reflection of you hiding from your results.

This brings us back to the psychology of money management. Many emotions can be generated by the simple process of adding up the numbers. This process can commonly generate fear. Fear of success (yes, it is common to be fearful when you are actually successful at something like trading), and fear of failure can be all too familiar.

Now is when you need to gather every molecule of discipline you have and start running the numbers. This doesn’t mean waiting until the end of the month and getting your calculator out. It means every day, tally up the numbers. It’s the only way to stay honest and accountable.

To get started on your recordkeeping, we’ve include diagrams in the book of all the trade posting cards and trade ledgers that are in The Trader’s Assistant, which has been honored with Stocks & Commodities magazine’s Readers Choice Award. You can photocopy these forms right from the book and get started.

Part Five: Design Your Own Plan

This is the fun part. Here you get to customize your own plan to fit your risk tolerance, your experience level, and your financial needs. We’ll walk you through the money management techniques at your disposal and will help you to design a realistic plan. This plan is one that you will continue to use and profit from.

GET YOUR HIGHLIGHTER OUT AND USE IT

Are you ready to get started? Don’t be afraid to write in this book (unless you are borrowing it from the library or a friend!). Jot down ideas along the way of how to apply these techniques to your trading system.

The beauty of a sound money management system like the one in this book is that it can be used in conjunction with any trading or investing system. These concepts are universal and will serve you well. If you have any questions on the material you are about to read, please contact me at Team@TradersCoach.com.

Good trading to you today, tomorrow, and always!

BENNETT A. MCDOWELL
San Diego, California
March 2008

PART ONE

Psychology of Risk Control

CHAPTER 1

It Just Ain’t Sexy!

Money management probably doesn’t come up as the number-one item on your top-ten list of fun things to study. That is, not until you start making money as a result of getting really good at it. The key for every trader is to discover the financial benefit to sound money management—and then all of a sudden, it becomes totally fun. Once you see how effective sound money management can be at ensuring profit and avoiding the risk of ruin, it might just become your favorite part of trading!

WHY IS MONEY MANAGEMENT SO BORING?

Upon hearing the term money management, you may think, “Why does money management have to be so boring?” Well, maybe that’s because it’s so much more exciting to get into a financial market with a flurry of activity and not a care in the world. And it’s just that kind of behavior that gets the average novice trader into trouble because they don’t yet own the perception that risk analysis and money management really is important.

Isn’t it much more fun to dream of the phenomenal huge financial outcome of one’s newly entered trade than to plan for the seemingly remote possibility that there could be financial loss? After all, why be negative?

At first glance, it seems that placing a trade and getting in the game is thrill enough in itself. What more could you ask for? That is, what more could you ask for, until the position unexpectedly goes in the wrong direction, generating a loss of capital. But, that’s only a paper loss you say, since the market will surely get back on track and go in the right direction. No problem!

Then it seems the market is not being cooperative, and for some reason, it does not comply with the plan (of making lots of quick cash) and it does not go in the desired direction. Instead, it continues in exactly the wrong direction. Isn’t that when the thrill of entering a great position instead becomes the anxiety of wondering how to get out of a not-so-great position? Of course, the adrenaline kicks in, the heart rate increases, sweaty palms appear, and the physical metamorphosis from thrill to dread quickly evolves.

So, let’s see, the position instantly gaps—again, it’s going in the wrong direction. How can this be? That gut feeling was so clear and compelling when we entered the trade. It was a sure thing, wasn’t it? We couldn’t have been wrong, could we? Now at this point, the trade is so far gone, we can’t afford to get out, can we?

Most of this evolution of a position gone bad has to do with entering the market and risking real cash without having a plan, a stop, and a tested money management system—before the entry.

It’s a pretty common occurrence, actually. It’s happened to the best of us. There are many reasons that it happens—ignorance, impatience, inability to admit we might be wrong, inexperience, or, worst of all reasons, an addiction to the adrenaline rush of taking on a position (for better or worse).

Regardless of the reason, I’m guessing that most of us would agree, it’s not all that sexy to lose money. It’s not much fun, either. The question is, do we find it painful enough to change our thinking and implement a money management plan now, or will it take another loss or two to bring the concept home?

The answer to that question is different for everyone.

PSYCHOLOGY OF RISK CONTROL

The psychology of risk control sooner or later begins with genuinely believing that you will benefit from a risk control plan. Then, it’s a matter of directing your resources toward that goal. Regarding resources, you’ll need to devote time to design a plan, allocate some money for purchasing tools and materials that will assist you, and then, most importantly, focus your emotional energy on rethinking how you look at money and the markets.

Maybe you’ll be one of the few lucky ones who will own the belief that risk control is important right off the bat. More often than not though, most traders learn this lesson the hard way—by losing money. Regardless, developing your risk control psychology will be a crucial key in developing a personal money management plan that works.

When you’ve mastered your psychology, you’ll experience less anxiety and will be able to implement your plan more consistently. There are often times when traders will design a terrific plan that emotionally they don’t adhere to because their psychology is not fully developed. It takes time, but as the profits increase, resulting from a sound money management plan, your psychology will gradually strengthen.

STEP NUMBER ONE: MAKE IT SEXY AND MAKE IT FUN

To begin with, making money is sexy and making money is fun. So, if you can translate these two understandings into a money management system, you’ll be way ahead of the game. For example, instead of dreading a stop out (which, by the way, is a natural part of trading) when your system tells you the trade has gone bad, think of it as getting one step closer to the winning trade.

From a probability standpoint, if your system generates six winners for every four losers, then the sooner you get the losers out of the way, the sooner you’ll get to ride one of the winners. That’s a whole lot more fun than focusing on some insignificant monetary loss from a stop out.

When I say insignificant, that’s because what we’ll be covering in the following pages is a strategy where all of your stop-loss exits will be set at a point where the most you will lose on any one trade will be 2 percent of your trading account. That is a manageable loss, and on a $10,000 trading account the most you will lose on any single trade will be $200. Not too bad, right?

By limiting your loss potential on each and every trade, you will reduce the anxiety associated with stop-outs and will automatically strengthen your psychology.

IMPORTANT NOTE: For some advanced traders, it is beneficial to risk more than 2 percent of their trading account. The amount these traders risk must be carefully calculated depending on their proven historical performance statistics. See Chapter 9 for the formulas to determine if your payoff ratio and win ratio performance warrant a higher risk than 2 percent.

FEAR AND GREED ARE NOT THE ONLY EMOTIONS IN TRADING

In the movie Wall Street , Gordon Gecko says, “Greed. . .is good.” Gordon may be a bit overzealous in his love of greed, but that is certainly an entertaining scene in the movie!

When the psychology of the markets is discussed, fear and greed are often the most common emotions that are bantered about. And yet, there are a number of other, equally important emotions in play.

Here are some negative psychological motivators (other than fear and greed) to consider when evaluating your own trading psychology:

• Regret

• Anxiety

• Blame

• Dread

• Anger

• Apathy

• Denial

Here are some positive psychological motivators to consider when evaluating your own trading psychology:

• Happiness

• Acceptance

• Anticipation

• Pride

• Appreciation

• Confidence

When evaluating your psychological and emotional motivators, you want to focus on ways in which you can reduce the occurrence of negative emotions and increase the occurrence of positive emotions. You may not decrease all the negatives, and you may not increase all the positives, but the growth goal is to strive in this direction.

PSYCHOLOGICAL MOTIVATORS

We’re all driven by both positive and negative psychological motivators. What a sound money management system will do for you is diminish your negative motivators and increase your positive motivators.

For example, if you know that the most you’ll lose on your $10,000 account is $200 on any one trade, that decreases and relieves an enormous amount of anxiety. Stress and anxiety are negative motivators, and the less of these you have, the more profitable you will be (and the more you will enjoy your trading).

As you gain confidence in your plan, you will begin to see your profits increase. There is a certain amount of pride that comes from generating greater profits on each trade, and that increased pride is a positive psychological motivator.

These are just a couple of illustrations of how to view your psychology. Ideally, you want to look at your own personality and emotional tendencies to determine which negative and positive emotions you experience while trading. The goal is to enjoy the process of trading—to decrease any negative emotions you may have and increase the positive ones.

CHAPTER 2

Confidence in Your Plan

If you don’t believe your plan will work, it won’t. That’s a rule that applies to most anything, kind of a self-fulfilling prophecy. Many things may stand in your way, a good plan but poor self esteem, an ego that doesn’t think you need a plan, or maybe just a poor plan. If you don’t believe in your plan (or don’t have one), get to the bottom why and make adjustments; it is now or never.

YOU GOTTA’ BELIEVE!

One of the greatest challenges for any trader is to finally come to the point where he or she sincerely believes to the very core of their being that a sound money management program is vital.

It is a stumbling block for a great many, since most individuals participating in the markets today just don’t believe that money management is particularly important. Analyzing the crucial and latest fundamentals, using the best technical software, most traders and investors believe that those items are the magic pill and should take priority over and above everything else. They think money management “just ain’t sexy.”