Learn Money Management Best Practices for Stock Trading

One of the benefits of Trades Diary is that it helps you manage your trading account balance and risk. This is a vital piece of the puzzle in terms of becoming a successful trader and is not a simple calculation to manage without a calculator, Excel spreadsheet and/or other tools.

If you bet on a stock and do not have a stop in place to limit your risk every time you enter a trade, you are unlikely to succeed in the long run. By placing a stop in the correct place with the correct number of shares purchased, you can limit the maximum amount you lose on a particular trade to a percentage of your trading account balance.

Losing a maximum of 1% to 2% of your trading account balance on a trade is generally a safe level of loss. A good rule to follow is one that Alexander Elder recommends. If you lose more than 6% of your account balance in a particular month, stop trading for the rest of the month and take some time to reassess what you might be doing wrong.

How to Make Money in your Trading Account Consistently and Limit Risk

You can think of making money as a trader by trying to get to the top of a building by taking different elevators. The elevators' rise and fall represent the rise and fall of various stocks. The idea is to get on an elevator that you hope will take you to your goal of reaching the top of the building, and get off that elevator if it starts to go down.

When you get off of an elevator and are on the floor of the building, it is as if your funds are in cash rather than invested in a stock. When you are ready, hop on another elevator (make a trade) in the hopes that this elevator will take you in the direction of your financial goals.

The elevators are constantly going up and down and you cannot press any buttons to control them. You simply must get off as soon as you realize you are going down and get on when an elevator is going up.

If you lose 2% of distance every time your elevator goes down and gain 10% of distance every time your elevator goes up, you can be on the wrong elevator at the wrong time 5 times for every 1 time you are right, and still not lose distance towards reaching your goal. If you are right more often than that, then you are actually moving towards your goal.

This is realistically the way trading works. You cannot be right 100% of the time. In fact, if you are correct 50% of the time, you are in fantastic shape.

There are winning trading systems in existence that have winning trades only 30% of the time, but still earn money in the long term because losses are taken quickly before the trade moves too far in the wrong direction, while winners are allowed to travel further in the right direction to earn maximum profits.

Risk/Reward Ration (RRR)

There is an old saying to let your winners run and to cut your losses quickly. However, it is not easy to know how far a stock will travel before it reverses direction. Having a winning trade turn into a losing one is not a good feeling. Therefore, I think it is a good idea to simply take profits at a reasonable level, such as 10% above your entry price, for example, or another target price level you think will be reached.

I prefer to calculate a Risk/Reward Ratio before entering a trade, where I know my target price to take profits at in advance. By setting an entry price, a stop price, and a target price immediately when I place my trade, I can calculate a risk reward ratio when going long on a trade with the following formula.
RRR = (Target Price - Entry Price) / (Entry Price - Stop Price)
By using an RRR, it is easier to manage risk, and you can set up your trades at night and not think too much about your trades while you are at your day job.

For example, we want to enter stock ABC at a price of $50 (Entry Price). We want to take profits when the stock price travels 10% higher to a price level of $55 (Target Price). We set a stop price according to some criteria, with the hope that the stock price will not travel against us and hit the stop. For this example, we pick a stop price of $48.5 (Stop Price). Plugging into the formula, we obtain the following RRR.
RRR = (Target Price - Entry Price) / (Entry Price - Stop Price)

RRR = (55 - 50) / (50-48.5)

RRR = 5 / 1.5

RRR = 3.33
Thus, in the example above, we are risking $1 in the hopes of gaining $3.33. If we only enter trades with this exact RRR, we can have one winning trade for every 3 losing trades, and still make a profit. In other words, if we enter three trades and lose $1 per share each time, but win $3.33 per share on the fourth trade, we are up $.33 per share overall. If we purchased 1,000 shares, this translates to $333 of profit.

Generally, it is a good policy to not take trades with less than a 3.0 RRR value. This way, you can be wrong 3 times for every time you are right and break even. You can come up with your own trading rules and trading system. This is general advice.