How to Trade in Stocks: Money Management
As discussed earlier by the author, the three important aspects of being a successful trader are: Timing, Money Management and Emotional Control. Let's discuss Money Management in this chapter.
Money Management: Livermore used to call cash – the lifeline of traders. A speculator without cash is like a store owner without inventory. His rule of not putting all the stakes at one price is an attribute of money management principle.
Firstly, decide the total quantity you want to purchase in an upward trending trade. Secondly, in an upward trending market, each additional purchase should be at a higher price. Thirdly, it is prudent to purchase a higher number at each additional purchase as an indication of higher conviction of the trend.
The trader should also establish a general upside target. Livermore believed in never exceeding losses of more than 10% of the invested capital. The 10% stop loss rule will help you NOT become an involuntary investor. This is a type of investor who went in as a trader but because of the losses, he refused to sell the trading stock and hence became an investor. Another stop loss is when the broker calls for additional margin money.
The other rule is to keep cash reserves. There are never ending streams of opportunities in the market. Hence you should also have some reserve cash in order to benefit from the same. Relevant quote on this by Livermore: “THERE ARE TIMES WHEN PLAYING THE STOCK MARKET THAT YOUR MONEY SHOULD BE INACTIVE—WAITING ON THE SIDELINES IN CASH—WAITING TO COME INTO PLAY—IN THE STOCK MARKET—TIME IS NOT MONEY—TIME IS TIME—AND MONEY IS MONEY.”
An interesting way to do the above money management task of “keeping reserve” is to take out 50% of your profits and keep it in bank FD.
Stick with the winners as long as the stock is acting right. This is basically to signify, not to exit prematurely. In the stock market, the money is never yours. It’s stock market money. Conversely, it is equally important to cut the trade when acting against you. This principle is known as Antifragility. Livermore very aptly said, “Profit takes care of themselves, Losses never do.”
We will discuss more on emotional control in the next chapter.
