Having good analysis is just part of the puzzle. I can assure you that if you have good analysis coupled with bad money management, you will not do well in trading. This is something I have personally witnessed in the past. There are many reasons for this, and I will give you one example here.
For instance, you may win a little when you win, as you are too eager to get out of the market when you win. You may also lose a lot more when you lose, as you are willing to wait for it to turn into profit. In other words, you can be good in your analysis, but you can still be losing consistently to the markets unless you have a solid money management plan.
You are almost certain to double, triple or quadruple your capital with a solid money management plan coupled with a good analysis method. A very important part of money management is having a good trading plan, which can be thought of as your game plan.
In terms of a trading plan, it’s essential to have an entry point, which was covered in my market analysis earlier. In addition to an entry point, you need to have your exit points as well. In my system, I have designed five different types of exits, and the two must-have exits are as follows:
The first exit is my target profit exit, where I exit with profits. Normally, I don’t have a single target profit exit. Instead, I use multiple exits so that I can turn my trade into a risk-free trade, or what you can call a FREE trade.
Let me explain how this is possible with an example. Suppose shares of XYZ are trading at $10.
A trader buys 100 shares of XYZ at $10. If XYZ’s price rises to $20, and the trader sells 50 shares at $20, the trade will have made a $10 profit per share. The total profit for the 50 shares sold based on the $10 profit per share will be $500 (50 shares X $10 profit).
This trade is considered as a risk-free trade because even if the trader loses their $10 per share investment, overall, they lose nothing.
Here’s why: if the trader lost $10 per share with a balance of 50 shares, it means the value of his shares has dropped to $0 per share. This would cost him $500 (50 shares x $10), but he has already taken a partial profit of $500 as mentioned earlier, so he wouldn’t actually lose anything.
This means the trade is risk-free – even if the share price drops to $0 from $20. The trader would either make more profits as the price continues to move up from $20
or break even (if price drops to $0), but wouldn’t suffer any losses.
Isn’t it exciting to know that you can make more profits without worrying about losses at all? If so, then the next exit is even more thrilling. Let’s get to it.
Another must-have exit is a stop-loss exit. While most people use a stop-loss to cut their losses and exit the market, you can also use it to protect your profits. The primary function of a stop-loss is to protect against big losses, but it can also protect profits. I use stop-loss to minimize my risk and maximize my profits.
Let me give you another example to help you understand it better. Based on what I’ve shared with you, let’s say the shares of XYZ have gone up to $30, and the trader puts a stop-loss to sell at $20. If the price drops back from $30 to $20, the trader will sell XYZ at $20 due to the stop-loss order placed at $20. If that happens, the trader makes a profit because their buying price is $10 and they sold it at $20.
In this case, the stop-loss is performing as a function of a profit protection mechanism, which secures a profit of $10 per share (since the trader bought the shares at $10 per share). Apart from using it mainly for stop-loss, a stop-loss can also be used for profit protection. What if XYZ’s price goes up to $40 or even $50? The stop-loss order can keep shifting upwards to protect even more profits.
Another important part of your trading plan is to decide the dollar amount you are willing to risk for the trade, which determines how much you can lose in a trade.
Once you decide the dollar amount to risk, you can determine the number of shares or contracts you can buy.
Typically, we use 1% to 2% of our capital for each trade. For example, if our capital is $100,000 and we use 1% for each trade, we would be risking $1,000 for each trade. Once we have determined our dollar amount of risk for each trade, we can proceed to calculate the number of shares to buy.
Here is an example. Let’s say shares of XYZ are currently trading at $1, and our entry price level to buy is also $1. Our stop loss level is at 90 cents, which means that if the price drops to 90 cents, we will exit the trade with a loss of 10 cents ($1 – $0.90) per share.
If our dollar amount of risk for the trade is $1,000, we can calculate the risk per share that we are willing to take. To do this, we subtract the stop loss price level from the entry price level, which gives us a difference of 10 cents. This means that we are willing to risk 10 cents per share for the trade.
To calculate the number of shares we can buy, we divide the dollar amount of risk by the difference between the entry and stop loss prices. In this case, we would divide $1,000 by $0.10, which gives us 10,000 shares. This means that if we buy 10,000 shares at $1 and the price reaches our stop loss at 90 cents, we will exit the trade with a loss of 10 cents per share, which equates to a total loss of $1,000.
Knowing beforehand how much we are willing to lose can help us feel safer and more confident in our trades. It is important to always calculate the risk and potential loss before entering a trade to ensure that we are not risking more than we can afford to lose.
Most people do not calculate the amount of risk they are taking when entering a trade, which can lead to unexpected losses. They may find themselves losing more than they are prepared to lose, such as $1,000, $2,000 or even more than $10,000.
It is important to also consider the risk-to-reward ratio in your trading plan. This is because it is similar to the odds payout in the casino model, and by determining it the right way, you can gain an unfair advantage.
To understand the risk-to-reward ratio, consider the example of risking $1,000. If instead of losing that $1,000, you make a profit of $1,000, then the risk-to-reward ratio is 1:1 or 100% risk-to-reward. If you risk $1,000 and make a profit of $2,000, then the risk-to-reward ratio is 1:2 or 200%.
In my trading community, we always aim for a risk-to-reward ratio of at least 200%, or a ratio of 1:2 or more. This is a number that we currently use and plan to continue using in the future.
Let me show you why this is very important. Suppose you are going to make ten trades with a risk of $1,000 per trade, meaning in every losing trade, you will lose $1,000. Let’s assume that in every winning trade, you maintain a one-to-two risk-to-reward ratio, meaning a 200% reward (profit) of your risk amount, which is $2,000 profit.
Let’s also say that you have a low accuracy in your trades, and you only have a 40% win rate, meaning you win only four trades out of ten and lose six out of ten trades. Your four winning trades (out of ten trades) will make you $8,000 because you maintained a 200% risk-to-reward ratio, and your six losing trades will cause you to lose $6,000. Overall, you will still make $2,000 of profit ($8,000 profit in four trades minus $6,000 loss in six trades) even though you have a low accuracy and only have a 40% win rate.
So always maintain a risk-to-reward of at least one-to-two or 200%. It may sound very simple, but I can’t stress enough how important this is, even though it is simple. Let me just say this: if you got nothing out of this book so far (which is unlikely), this is going to help you a lot if you only follow this. Remember, I mentioned “at least,” so you can go for 300% or even 400% or more.
Now, once I have done my analysis, I proceed to do my risk management mainly by developing my trading plan so that I have an overall view (based on the plan) of what to expect after I’m in the trade.