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Risk (Money Management)

Posted By Robert On Thursday, November 28th, 2013 With 0 Comments

Risk or money management are all about protecting yourself when trading shares. Outside of controlling your emotions and being disciplined about following your trading strategy, this section is the next most important lesson to learn and apply throughout the course of your trading life. The term risk management means exactly what it says. The ideas that pertain to this aspect of trading ultimately help in managing the risk placed on a particular trade namely how much are you willing to lose on a trade. At this point we come to the idea of a stop loss. For any rational being, losing all the money placed in a particular trade is, well, a bit dumb. So to protect ourselves and coming out with something if the trade goes against us, we use a stop loss or in other words a level to which we will allow the stock to fall before we sell, regardless of the loss. It is, emotionally one of the most painful things to do, but if as a novice investor you never got out and lost all the money you placed in a trade, you will be thankful for having learnt to use a stop loss as its much better to lose 10% than 100%. Money management is similar but it is concerned with the % of your overall capital that you are willing to trade. Tutorials, experts and general investors differ on what % it should be but most range between 0.5% and 10%. You have to do your own maths on this one and think of the benefits or weaknesses of spreading your money out on different stocks. Just remember, if you are investing in 100 companies as opposed to 10, you risk a lot less if one goes against you. Both disciplines are ultimately concerned with protecting yourself from losing all your money in one go on a bad trade. Dependent upon how quickly this becomes a main theme in your trading strategy depends upon how long you will last as an investor.

The first and most important rule is ‘Never invest more money than you can afford!’ You will see this in any rational book or website which talks about money management. Trading is not a game where you can play with hypotheticals then walk away if it did not go your way. When you lose a trade, you lose money. From my own personal convictions, money is not a luxury that we can afford to play around with or indeed waste. I believe, particularly in the west, the 2007/8 Credit Crunch which was so heavily reported on was a major course of our complacency as far as money is concerned. Debt became to easy a thing to obtain and before long, when particularly the banks concerned started to weigh up the risks of all the debt, it became clear that there just was not enough of the stuff to go around. I generalise here, the situation which linked in with the way banks invest, the housing market bubble, the way banks lend to each other and their clients make the situation a lot more complicated. But irresponsibility as far as money was concerned, I believe, was the route cause of the slide in the markets at this time. I feel I am justified in this as most economists, traders and anyone with a good understanding of the problem came out and said that the banks need to be more regulated to stop this happening again. So through legislation, the importance of money and debt would be accounted for by law making the system as a whole more wary of how it views money/debt in the future. As a private investor the same attitude should apply. People have mortgaged homes, sold cars, borrowed money from banks, etc. to raise capital to trade on the stock markets. I hope, for your sake, this does not include you.

The next most important thing to remember is ‘Never borrow money to invest!’ If for example I invested £100 in a share and the company went into liquidation, I would lose £100. Not something I wish to do but that was how much I put aside for that trade, I knew the risks and it was worst £100 to me. If I invested £100 of my own money and borrowed £100 and made a trade of £200 and lost it all, I have lost the equivalent of 200%. So now, not only have I lost my £100, something which I did not like but was prepared for, but I also have to find another £100 to pay back what I borrowed, money that I could have used in another trade, or probably in most cases, money which I do not actually have and will have to live off less for the next month to cover it. I assume I am not talking to idiots who have no idea how debt works or have not at one time or another felt its effects. It is important to understand however that this is a serious business and before you can be successful at it, you need to be disciplined like all successful traders have been.

That’s about it as far as risk and money management go. There is a lot more work to do in building a structure to help govern ones risk and money management but the basics can be summed up in the two previous points. There is another section to this which you should be aware of as it is common amongst many forms of trading, especially outside of buying and selling general shares. The items concerned are:

Margin and Leverage

Margin is the amount of money you need to have in your account to cover a trade. This occurs regularly if you are spread betting or trading currencies, futures or options. For example in spread betting, you might place a trade of £1 for every point which means if it goes up 10 points (commonly called pips) you gain £10, but if it goes the other way and you lose 10 points, you lose £10. So you are not trading £1 like you might be with a share. Also the losses can be excessive. The margin is basically money you need to have in your trading account to cover the trade in case you lose. If you lose, a lot, the margin will cover what you have to pay back to your broker. It is a little like borrowing money to make a trade and we know that we should never do it. Trading with margin should only be done when you know how the market completely works and have enough experience in normal trading to potentially move to the more lucrative aspects of the market.

Leverage is another way of basically borrowing money to invest with and it is something provided by the broker. Basically if you have £1000 to invest you could buy shares in Google for example and buy a certain number, lets say 10. But if you were trading currencies for example and the broker was willing to offer up to 200% leverage (which is not uncommon), your £1000 now is equivalent to £20,000. To profit from currency trading without leverage would be very difficult unless you were able to invest millions, hence its requirement in trading currencies but again, the real figure of what you could technically lose is much greater than the initial investment. So not only could you lose your £1000 starting capital but also you could be staring at a much larger debt to pay back if it goes badly against you.

Without margin and leverage, certain aspects of the market would cease to exist and whether it be right or wrong is not for me to say. Be aware that these things exist and be ready for the consequences, particularly if you rush in without firstly weighing up what you can literally lose.

Note: But remember that if a share opens on the morning below your stop loss then it will either sell at the open price or whatever price is available when they get around to selling it. Some brokers I think set a limit on how low you want the trigger to sell so it won’t sell below the trigger. Also some brokers will not trigger a stop loss until 5 minutes after the morning opening, to avoid market noise, as is the case with iWeb.

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