Dear Student,
Over the past couple of weeks, we’ve talked about the foundational secrets of trading, including:
The Five Charts I Analyze to Profit Every Week…
One of the key formulas for profits when trading options – AND…
Using the “Greeks” to lock in profits on major price swings.
And, as I’ve previously said, it’s important to cover these basics ahead of the most important pattern starting in just 17 days.
As you know, November marks the beginning of the seasonal “Best Six Months” pattern – the most profitable stretch on the calendar.
Plus – falling interest rates… cooling inflation… record-low unemployment numbers… while the probability that the U.S. will fall into a recession continues to decline…
All of these factors are converging on the markets right now, giving us a very bullish picture through the end of the year.
But that’s just the beginning…
Because what’s really going to drive the markets between now and December 31st is this once-in-a-generation election pattern that we’ve been talking about.
Now, starting next week, we’re going to hone in on a potential Trump win in November, the market’s biggest winners and losers – and the best ways to profit.
But before we do, I want to share one of the most important lessons I learned early in my over 30-year career…
It’s what all successful traders have in common, regardless of strategy: They stick to their money management rules. Now, that may sound boring, or even scary… But don’t worry – it’s neither.
Whether you trade stocks or options, all it takes is sticking to these four simple rules of money management.
RULE 1: Predetermine Your Maximum Risk Level
The first rule of money management is to determine how much of your capital to devote to stock or options trading.
Any capital devoted to options trading is for shorter-term trades and should be kept separate from the capital used for long-term, buy-and-hold investments (like stocks).
With a figure for that shorter-term “trading money” in hand, you’ll also want to decide how much of it you want to risk per trade…
As always, I recommend you work with your financial adviser to determine these numbers for your individual circumstances.
But when I educate my students, we run scenarios based on a theoretical $25,000 dedicated to a stock or options trading account. We then risk no more than 2% of this capital ($500) on any one trade.
That’s a great place to start because even if you were to lose everything you invested in any single trade, you’d still only end up losing 2% of your overall “trading money.”
Now, it’s crucial that, as your trading wins add up and your account increases in size, you keep this 2%-per-trade rule in place.
No trading system is perfect, and you need to use trading rules that let you weather some losing trades without endangering your whole “trading money” account.
And remember, as the size of your account increases, what 2% translates to will change. For a $25,000 account, 2% is $500 – but once you’ve doubled your account to $50,000, 2% per trade means $1,000.
Once you’ve predetermined your maximum risk level, it’s time to pick a strategy for minimizing losses…
RULE 2: Set a Stop-Loss Approach
A stop-loss is a tool that lets you automatically get out of a trade if it starts losing too much in value. In other words, it lets you cut your losses short.
Four Simple Rules That Will Turn You into a Trading Expert
Now, there are a couple of ways to go about using stop-losses. The usual way is to risk a set percentage, say 50%, of the money you’ve devoted to the trade (the 2% of your “trading money” mentioned above).
This is called a “stop-loss percentage” – in the example above, where you’re limiting your risk to 50% of your investment, it’s a “50% stop-loss.”
What this lets you do is close your position and recoup as much of your investment as you can if the trade falls 50% or more from where you opened it.
Having a stop-loss percentage in place may just be what you and your account need to preserve capital on a trade that could otherwise have blown out – and left you with a 100% loss on the trade.
Of course, sometimes what happens is that a trade falls 50% and traders panic and get out, only to see the trade recover and even turn profitable.
Let me tell you, it’s happened to me more than once…
That’s where the cost-of-risk stop-loss approach comes in. This is where you risk the full amount of your trade (100% of your investment), and leave the profit side of the trade open.
This might sound preposterous, but especially for options – which can swing very wildly in price – it gets rid of the stress of always paying attention to price movements and lets you capture profits without limitation.
That’s where the third rule of money management comes in. Regardless of your stop-loss approach, you’ll need to follow this closely…
RULE 3: Determine Your Position Sizing
Position sizing means deciding ahead of time (before spending a single penny on the trade) how many shares or option contracts you can take on for the trade.
In our example of risking no more than $500 per trade, let’s say you have an option that cost $2.50. This means your cost per contract (the lowest amount you can actually buy) is $250.
In this case, given your maximum risk level, you can buy at most two contracts, for a total of $500.
If you decide on that position sizing and the option value goes to zero, you will lose the full $500.
But remember, because of your predetermined risk level, that’s just
2% of your total “trading money,” which you’ve already deemed an acceptable loss.
Finally, you need to make sure your trading strategy fits your account size. Here’s what I mean…
RULE 4: Adapt Your Trades to Your Account Size
Given our theoretical $25,000 account and 2% (or $500) maximum risk per trade, many stock trades will be difficult to execute.
Quite simply, shares can be expensive enough that you won’t be able to buy very many with $500.
While you’ll be able to get 100 shares of a $5 stock, $500 will only get you five shares of a $100 stock. That’s something to consider – and is a key advantage of options, which give you leverage over more shares for a lower risk.
So, unless you have a huge trading account – with, say, $250,000 allocated to stock and option trading with the same 2% ($5,000) risk-per-trade rule – consider trading cheaper stocks or using options strategies instead.
And always remember – money management is what separates wealthy traders from those who just get lucky once in a while, but lose it all over the long term. In fact, I consider it the key to building a fast fortune.
Have a great weekend!
Tom Gentile
America’s Pattern Trader