BY GIBBONS BURKE

M oney management is likesex: Everyone does it,one way or another, butnot many like to talk

about it and some do it better than oth-ers. But there’s a big difference: Sex siteson the Web proliferate, while sites devot-ed to the art and science of money man-agement are somewhat difficult to find.

There are many, many financial siteson the Web that let you track a portfolioof stocks on a glorified watch list. Youenter in your open positions and you geta snapshot, or better yet a live, real-timeupdate, of the status of your stocksbased on the site’s most recently avail-able prices. Some sites, like Fidelity’s,provide tools that tell you how yourportfolio is allocated among variousasset classes such as stocks, mutualfunds, bonds and cash.

While such sites get at the idea ofmoney or portfolio management, theoverwhelming majority fail to providethe tools required to answer the centralquestion of money management: “WhenI make a trade, how much do I trade?”(Try and find the topic of money man-agement on the Motley Fool site.)

We’ll discuss how to measure andmanage trade risk and where to find thetools to help do it in a responsible andprofitable manner. The key underlying

concept is to limit how much money youare willing to let the market extract fromyour wallet when you make losingtrades.

When any trader makes a decision tobuy or sell (short), they must also decideat that time how many shares or con-tracts to buy or sell — the order form onevery brokerage page has a blank spotwhere the size of the order is specified.The essence of risk management is mak -ing a logical decision about how much tobuy or sell when you fill in this blank.

This decision determines the risk ofthe trade. Accept too much risk and youincrease the odds that you will go bust;take too little risk and you will not berewarded in sufficient quantity to beatthe transaction costs and the overhead ofyour efforts. Good money managementpractice is about finding the sweet spotbetween these undesirable extremes.

Figure 1 (below) shows the relationshipbetween the long-term result of a seriesof trades and the amount of risk takenon a per-trade basis.

If you risk too little on each trade,shown by the undertrading zone, thereturns will be too low to overcometransaction costs, small losses and over-head (quote feeds, electricity, rent, sub-scription to Active Trader magazine, etc.)and trading will be a losing proposition.

Risk more and the returns will incre a s e ,but note that the potential d r a w d o w n(account losses you will need to endure toget the return — another cost of doingbusiness) always increases as you incre a s ethe per-trade risk. Returns continue toi n c rease moving into the overtradingzone. Trading at the peak of the potentialreturn curve is very difficult psychologi-cally because the per-trade drawdowns

68 www.activetradermag.com • July 2000 • ACTIVE TRADER

RISK Control and MONEY Management

Managing YOUR MONEYYOUR MONEY

FIGURE 1 RISK vs. REWARD AND DRAWDOWN CURVE

Proper money management is a function of finding the point that maximizesreturn within acceptable risk parameters.

1 2 3 4 5 6 7 8 9 10 11 12 13Risk taken

Sweet spot

Overtrading

Undertrading

Drawdown

70

60

50

40

30

20

10

0

-10

-20

-30

-40

M

can be extremely high, and the margin ofsafety for dealing with unexpectedly highlosing trades is very low. In other word s ,y o u ’ re getting into territory where onehuge loser can blow you out.

The best place to live on this curve isthe spot where you can deal with theemotional aspect of equity drawdownrequired to get the maximum return.How much heat can you stand? Moneymanagement is a thermostat — a controlsystem for risk that keeps your tradingwithin the comfort zone.

It’s surprising that even many activetraders and investors have no idea whatmoney management is about. They gen-erally entertain a fuzzy notion that it hasto do with setting stops, and that disci-pline is involved to make sure you exe-cute the stops when they are hit, but

their understanding doesn’t go muchfurther. Most people seem content to lettheir brokers track their trades for them,and the tools provided by the brokeragesites are adequate to the task.

But none of the online broker ratingservices tell you about brokers who pro-vide the tools to help you manage theserisks, and none of the traditional onlineor even most hyperactive day tradingb rokerage firms seem to cover thisimportant contributor to trading success.

Why is this? Perhaps it can beexplained by the extended bull run thismarket has enjoyed since 1982, and the

speculative, maniacal extended leg ofthe bull market fueled by the dot.comland rush since 1997. This type of market— where making money consists of tak-ing a ride on the back of the bull trendand buying the dips — tends to turn themerely bold (and possibly reckless) intomarket geniuses. The perceived risk instock market investing has been verylow, so the need to manage that risk hasnot been a pressing concern. Why worrywhen it will always come back and youcan make a killing if you buy more?

More important to success than man-aging risk was the ability to charm yourbroker into getting you into the latestIPO allocation.

There are really two types of peopleoperating in the financial markets:traders and investors. It is useful to

understand the difference between thetwo — it may explain, in part, why somany people ignore risk management.

Many people who call themselvestraders are, in reality, active investors.The typical investor only purc h a s e sstocks and buys as many as possiblewith all the available cash in his or heraccount. The risk-free position, for thetypical investor, is to be fully invested instocks for the long term, because, as weall know, stocks always go up. Whenactive investors get more investmentcash, they plow it into their mutualfunds or buy individual stocks.

The investor’s game seems to consistof selective hitchhiking on a freewaythat is only going in one direction withthe object of getting a ride from theMercedes driving in the fast lane. Theydon’t know how far the car is going to goand they don’t really know when to bailout when the car starts driving inreverse.

They are slow to switch cars when onehits the breaks, runs out of gas or blowsa head gasket. There is a great amount ofhope and faith involved.

Many of these active investors don’tpay attention because they operateunder the assumption, reinforced by a20-year old bull, that the market eventu-ally will go up again and the safe thingto do is hold on or, smarter yet, buymore to lower the cost basis on the posi-tion. In this game it doesn’t matter verymuch whether the car has good brakes

or seatbelts — the gas pedal and cruisecontrol are all that matter.

This sort of trading can work in goodtimes, but when the bull turns into abear, there is going to be a big pileup offancy cars on the freeway full of driverswho don’t know how to deal with thereality of investing risk.

Good t r a d e r s operate diff e re n t l y. Ifbuy-and-hold investing is like hitching aride on the freeway, short-term, activetrading is more like a demolition derby.Traders are not loyal to the stocks theybuy and sell. They measure the risk of

ACTIVE TRADER • July 2000 • www.activetradermag.com 69

continued on p. 70

For many traders, money management is the ugly stepchild of the trading family.

But you can ill afford to neglect this aspect of your trading plan.

H e r e ’s a breakdown of the fundamental money-management concepts

you should understand, and tools and ideas on how to implement them.

Faith, hope and p r a y e r should be reserved for God Ñthe m a r k e t s a r e f a l s e and fickle idols.

A few Web sites provide soft-ware or Web-based tools forunderstanding money man-agement. Most of the large

finance sites do a fair job at letting youtrack the value of your investments,but none of them are really suited fortracking the performance of a tradingprogram — for that you need a piece ofsoftware.

The popular finance software pack-ages, such as Quicken and MicrosoftMoney, can track the history of yourtransactions but don’t do as good a jobat treating these as trades. They’refine for showing you the value of yourportfolio, and can save you timepreparing your tax return, but they arenot suited to executing the steps out-lined in the main story.

Table 1 (right) is a list of sites andsoftware packages that help with thesetasks, some better than others. MoneyMaximizer, software written by tradersfor traders, is a good package for man-aging your trading risk by sizing yourtrades to the amount of risk you want

each trade. They may have profit objec-tives but more commonly they use strictrisk management as brakes and seatbeltsto protect them in the melee and allowthem to maneuver quickly. Success inthis game is often more dependent onthe use of brakes than the acceleratorpedal.

Bad traders bring the biases and habitsof the freeway-hitchhiking investor intothe demolition derby of short-term,active trading, which re q u i res complete-ly diff e rent skills and a unique way ofthinking. These traders go beyond sim-ply buying dips and constant-dollarinvesting with all their cash: They tradeon margin, borrowing money from theirb rokers to buy more dips and invest inm o re stocks. When they are tapped outon margin they use credit cards to plowm o re rental money into stocks — with lit-tle re g a rd to the risk that goes along withthis degree of leverage.

They are entering the demolitionderby ring in a borrowed V12 Mercedesand, because they are not used to man-

aging risk, they don’t understand how toread the speedometer, operate the brakesor fasten the seatbelts.

You need to perform the followingimportant money management chores todo the job properly:

• Determine how much you are will-ing to risk on each trade.

• Understand the risk of the trade youare about to take and size the tradeappropriately.

• Track the trade going forward.• Pay attention to your risk points;

take small losses before they become biglosses.

• Review your performance.

The most important decision you need tomake is how much you are willing to riskon each trade relative to your entire port-folio. For example, many of the toptraders in Jack Schwager’s Market Wi z a r d sbooks said they limited this amount to

less than 2 percent of their stake. The reason to keep this number small

is to protect yourself from a series oflosses that could bring you to the pointof ruin. Losing trades are a fact of lifewhen trading — you will have them. Thekey is to limit those losses so that youcan endure a string of them and haveenough capital to place trades that willbe big winners.

It’s easy to determine how much riskthere is in a particular trade. The firststep is to decide — before you put thetrade on — at what price you will exitthe trade if it goes against you. There aretwo ways to determine this price level.The first is to use a trading methodbased on technical analysis that will pro-vide a reversal signal or a stop-loss pricefor you.

The second is to let money manag-ment determine the exit when you don’thave a technical or fundamental opinionabout where the “I was wrong” price

70 www.activetradermag.com • July 2000 • ACTIVE TRADER

TABLE 1 SOFTWARE SITES — SIZING THINGS UP

Software Type Risk Mgmt? Company

Athena Money Software Yes International Institute Management of Trading Mastery, Inc.

Fund Manager Software No Beily Software

kNOW Software Web site Yes

Money Maximizer Software Yes Trading Research Design

Stocktick Webware No NAC Consulting

StockVue 2000 Webware No NQL Solution

QCharts Software Yes Lycos/Quote.com

Trade Tracker Excel Yes TraderCraft Company

Medved Quote Tracker Webware No 2GK Inc.

Money 2000 Software No Microsoft

Quicken Software No Intuit

Captool Software No Captools Company

Portfolio Web site No Quote.com

TradeFactory.com Web site Yes TradeFactory.com

Money Web site No Microsoft Investorcontinued on p. 66

Tools for understanding and practicing good money management

ACTIVE TRADER • July 2000 • www.activetradermag.com 71

point is. This is where you draw a line inthe sand and tell the market that it can-not take any more money out of yourwallet.

The point is that no matter what yourapproach — whether technical, funda-mental, astrological or even a randomdartboard pick — you should not tradeor invest in anything without knowing,at all times, what your exit price will be.You need to know this price ahead oftime so that you don’t have to worryabout the decision when that price isreached — the action at that pointshould be automatic. You won’t havetime to muddle it out when the market isscreaming in the opposite direction youthought it would go!

If you are using the first method, youcan use this formula to determine howmany shares of stock to buy:

where

s = size of the tradee = portfolio equity

(cash and holdings) r = maximum risk percentage

per trade p = entry price on the tradex = pre-determined stop loss

or exit price

For example, Belinda has a tradingaccount with a total value (cash andholdings) of $100,000 and is willing torisk 2 percent of that capital on any onetrade. Her trading system gives her asignal to buy DTCM stock trading at$100 per share and the system says thatthe reversal point on that trade is $95.Plugging this into the formula tellsBelinda that she can buy 400 shares ofDTCM. The cost of this investment is$40,000, but she is only risking 2 percentof her capital, or $2,000, on the idea.

Belinda then gets a tip from her broth-er-in-law that KRMA is about to take anose dive from its lofty perch at $40because he heard from his barber that

earnings of KRMA will be well belowexpectations. She’s willing to go shortanother $10,000 of her stake on this idea.She studies a KRMAchart and can’t seeany logical technical points that wouldbe a good place to put in a stop, so sheuses the money management method todetermine the stop according to this for-mula:

where:

x = pre-determined stop loss or exit price

p = entry price on the tradei = investment amounte = portfolio equity

(cash and holdings)r = maximum risk percentage

per trade

Since she’s shorting KRMA, the valuefor i, $10,000, should be negative.

s = erp-x

Web Address Price Comments

www.iitm.com/software/ii05002.htm $12,500 Associated with the money management practicesof Dr. Van Tharp, an investment psychologist

www.beiley.com/fundman/desc.html $39; manual $2 Specially suited for tracking mutual fund performance

www.moneysoftware.com n/a Software is no longer available but the site has very good information

www.moneymaximizer.com free trial; Full $159; Pro $259 Written by a top-rated hedge fund manager

www.naconsulting.com $24.95 —

www.stockview2000.com free; banner advertisements —

www.qcharts.com/ $89/mo. Quote sheets track stops; calculate trade and portfolio risk updated in real time

www.tradercraft.com/download freeware fee $25 Excel spreadsheets updated in real time

www.medved.net/QuoteTracker free; no ads $60 —

www.microsoft.com $64.95 —

www.intuit.com/quicken —

http://captools.com $249 - $3,500 Complete professional tool; includes tax accounting

www.quote.com free Daily portfolio valuations; e-mail alerts

www.tradefactory.com $299 + $99/mo. Based on the famous Turtle Trading methods

www.moneycentral.msn.com/investor

continued on p. 72

x = p(i-er)

i

to take. The interface can be a bitclumsy and the program leaves a fewthings to be desired, but it’s a goodoverall package; the “Size-It” tool(right) sizes your trades based on riskrelative to core equity.

Another software package thatshowed a great deal of promise — but isno longer produced — is kNOW Softwareby MoneySoft.com. The Web site pro-vides an excellent online manual andthe tutorial is a worthwhile and instruc-tive guide to good money managementpractices.

The Athena software looks good, too,but its price tag is rather steep:$12,500. The site is worth a visit — Dr.Van Tharp provides some good informa-tion on proper money management.

Excel makes an excellent tool forimplementing the formulas listedabove. (It’s what I use for my own trad-ing, in combination with Quote.comQCharts live quotes package. TheQuote.com QFeed includes an add-in topower Excel spreadsheets with livequotes. The spreadsheet is freewareavailable at no charge on my Web sitelisted in the table.)

Some of the tools listed are a crossbetween software and a Web site(“Webware”). These packages are gen-erally free but are paid for by bannerads displayed in the window of the soft-

ware. The Medved quote tracker letsyou turn off the ads if you register andpay the $60 fee.

Money management is a complex sub-ject, but one that is necessary to mas-

ter if you want to enjoy a sustainedtrading career. The books listed in“Money Management Reading” (aboveright) provide additional information onthis multi-faceted topic.Ý

72 www.activetradermag.com • July 2000 • ACTIVE TRADER

Plugging these values into the formulaabove would tell Belinda that her stopprice on the short sale of KRMA shouldbe 48. If she didn’t want to assign a highconfidence on this trade she couldreduce the max risk to 1 percent (r=0.01),which would bring the stop down to 44.

Another worthwhile variation tothese methods is to use Ed Seykota’s“core equity” for e in the formulas ratherthan the total value of all holdings in theportfolio. Core equity is what you haveleft when you subtract the total value atrisk in all open positions from the totalequity; value at risk in each trade is cal-culated by multiplying the number ofshares in the position by the differencebetween the current price and the stopprice on that trade.

Using the core equity value as thebasis for sizing new trades has the desir-able effect of automatically reducing the

risk exposure on new positions whenmarket volatility in your existing posi-tions increases.

It is important to watch your positions asthey pro g ress and adjust your stopprices as the market moves in yourdirection.

In the first example, if DTCM movesfrom $100 to $120 and the stop is left at$95, what started as $2,000 or 2 percentat risk is now $10,000 (9 percent of thetotal equity) at risk.

The mistake most people make is toconsider trade winnings on open “housemoney” — that somehow this money isless painful to lose than the money inyour back pocket.

This is a bad mental habit. If losing 2percent of equity on a trade would bepainful to Belinda when her account was

at $100,000, losing 9 percent after thestock has moved to $120 should be sev-eral times more so. Moving your stoploss up with the price on a winning tradedoes several good things: It locks in yourprofits and if you are using core equityto size new positions, it will allow you totake more risk on new trades.

Never move a stop backwards fromits initial price — stops should always bemoved to reduce, never increase, theamount of risk on a trade.

Past the initial risk you are willing totake, stops should be a one-way valvefor the flow of money from the market toyour account.

A money management plan will only beuseful if you do what it tells you. Thismeans planning your trades as outlinedabove and trading your plan. If a stop

Tools for understanding continued from p. 71

FIGURE 2 SIZING THINGS UP — MONEY MAXIMIZER SAMPLE TRADE

The Money Maximizer’s “Size-it” tool calculates how many shares to tradebased on risk relative to core equity.

price is hit you must take that hit. If you find that your system is giving

you stops that are constantly getting hit,then perhaps you should re-examine therules of the system — but don’t messwith your money! Second-guessing theapproach will cause you to take on morerisk than you planned, increasing thechances that a bad trading system willruin you. Once your stop is gone, howwill you know when to get out next?

Take your losses when they are smallbecause if you don’t they are sure to getlarge. In this regard, discipline is of thehighest importance. It is a cardinal mis-take not to take a stop if it is hit. It’s evenworse if the stock comes back and turnsthe trade into a winner because now youhave been psychologically rewarded formaking the mistake.

Get out quickly and re-assess the situ-ation. If you think it will come back, puton a new trade with a new stop. Faith,hope and prayer should be reserved forGod — the markets are false and fickleidols.Ý

MONEY MANAGEMENT READING

Title Author Publisher, Date

Against the Gods: The Bernstein,Peter L. Wiley, 1996Remarkable Story of Risk

Market Wizards, The New Schwager, Jack D. Harper Business,1992

Market Wizards: Interviews Schwager, Jack D. New York Institute with Top Traders of Finance, 1989

Money Management Balsara, Nauzer J. Wiley, 1992Strategies for Futures Traders

Quantitative Trading Gehm, Fred Irwin, 1995and Money Management

The Four Cardinal Babcock, Bruce Irwin, 1996Principles of Trading

The Futures Game: Who Teweles, Richard McGraw Hill, 1987Wins, Who Loses, Why? and Jones, Frank

The Mathematics Vince, Ralph Wiley, 1992of Money Management

The New Commodity Kaufman, Perry J. Wiley, 1987Systems and Methods

The New Money Management Vince, Ralph Wiley, 1995