The art and science of money management

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• 0:00Speaker 00

  Happy Friday, folks. Hope you had a good week. So, listen, this lesson's about money management, which I don't think is spoken enough about because everyone wants the new opportunity, what's the best chart. But, like I said, it starts with position size. And then, if you have several names on all at the same time, you have to be considered with what we call portfolio heat. Now, this is the concept of... Let me take a step back. When you put a position on, right? You have your position size, you have your entry, and then you have your exit, your protective stop. And so then, the distance between those two prices, multiplied by your position, is what you have at risk. Now, if you multiply that across the two, three, or four names that you have on,

• 0:45Speaker 00

  we would call all of that your portfolio heat. So if you're risking 1% for every trade that you have on, you have four trades on, your portfolio heat's 4%, which means, again, you get to temper and set the thermostat for how much risk you can take. Now, I might have that much risk on, but the 4% would have already come from gains that I already have that are unrealized in the marketplace. I don't want to be risking so much of my corpus, right? The initial amount of money that I would be putting into the account, my starting balance. So if I put in 50K, say, for example, into an account, and I was drawing it down to, say, 47K, I'd be very, very... I'd be moving around with a lot of trepidation

• 1:28Speaker 00

  and smaller position sizes to kind of trade my way out of the drawdown. Now, if that goes to, say, 55, maybe 60K, now it's a little different because I have 10,000 of money that I've already earned, that I would take that money and kind of reinvest it into the positions. Eventually, I might get much larger as those positions start to move in my favor. But I'm always aware of what the overall portfolio heat is. So if I get to 60K, I might have 3%, 4% on, who knows what it is, of that 60K. So I know, like, what is... Okay, if I get knocked out on all of them, what's the worst-case scenario? Think about that number. Obviously, it's aggravating, it might be frustrating, but can I live with it?

• 2:11Speaker 00

  Because, you know, when you think about running money, this is going to happen to you. You're going to have these types of moments where, unfortunately, the market's going to move against you from time to time. And sometimes correlations go to one, or they get very close to one another if you might have, say, you know, Nvidia, Intel, or Micron, or AMD, right? The whole sector can move against you for any one particular reason. And that could make you feel unhappy. So, think about when you... It's not just on a per-possession basis. Think about the money management rules that you'll deploy. I tend to not try to cherry-pick things and say, like, "Okay, I'm going to have this stop here,

• 2:55Speaker 00

  and I'm going to have that stop that's going to be different and have varying amounts of money at risk across the positions." I try to tend to be very consistent. As I mentioned earlier in the week, I vacillate between what is like a percent-based risk and then also one that might be based on structure, even though the amount of money at risk is the same. Sometimes, there is no structure, so I'd rather go with a bigger position and use a percent-based stop rather than say, "Okay, well, the structure support is more than 1ATR, for example, away," which would induce you to have to trade a smaller position. Normally, I would just trade the bigger piece and use an ATR stop and deal with the frustration or the aggravation

• 3:39Speaker 00

  of getting knocked out of something. But it's still defined. So you can do both. You can vacillate between using a percent-based ATR-style stop or maybe a set-dollar value and/or structure, but it should be the same net amount, right? So if you're using structure, you would have fewer contracts or fewer positions, right? So, to me, the money management part is of primary importance to knowing how to make money. Also to consider is, like, how much money do you have in your account before you would have to go on margin? So if you have, say, 25K, it might be hard for you to buy a meaningful position in some of these stocks that are, you know, say, $200 to $1,000 a share.

• 4:23Speaker 00

  Even if they're in uptrends, they take up a lot of cash, and you might have to end up having... You know, you might have your whole account, right? If you bought a $2,000 stock with 25K and you bought 10 shares, you know, the thing might move $20, $30, $40 in a day, but you're going to have all your money tied up in that name. So you'd have to think about risk management from an overall portfolio standpoint, not just on a per-name basis and/or portfolio heat standpoint. That might induce you to have to take otherwise really good-winning trades off because you can't take that risk home overnight because your account has 80% of your capital in one name. So when you do your screens, and you can go to bar chart and just look under stocks

• 5:07Speaker 00

  and look at the 52-week highs and lows and see which are the larger-cap names, and then scan them for names that are, say, you know, $40 to $60 a share, and see if that would better fit as long as it has a lot of liquidity, right? You want a lot of liquidity because that also means that there's probably a very healthy options market, which is very, very good. So people who trade the thing can lay off their risk and/or use options as a surrogate. So either way, that's really good for you when there's that much liquidity. So, you know, think about how much of your account would you put in to maintaining a position without using margin? Now, the amounts vary, right? If you read the Bill O'Neill's book,

• 5:53Speaker 00

  he suggests that you have, you know, five or six names. So say it's five, it's easy to divide that into 100%. So you're looking at 20% of your account. Not how many... Forget the contracts and forget the shares. You know, he was talking about stocks. But think about how much capital that would tie up of your account, how much buying power. I think most of the platforms are good in saying that. And maybe start with, say, 5% or 10% of your overall capital into a name and then build into it so that you hit a max of, say, 20% before now you have to move on. And think about those other four risk units of 20% of your capital as helping you diversify so that you don't over-indulge in any one particular name, despite how strongly you might feel.

• 6:38Speaker 00

  Now, I know guys, and so do you, who have developed an enormous and amazing sense of timing. And they very well may look at trading 10 times their capital because they work through a broker-dealer. Broker-dealers, if they're a general, you know, clearing firm, I think they get 8 to 1 on their own money

• 7:00Speaker 00

  in the first year with a minimum of 250K of net capital. In the second year, that kicks out, I think, to 15 to 1. So that's how some of these prop-trading firms are able to generate and let you trade off of their leverage once you've proven yourself. And I'm talking about real money at that point. I'm pretty sure it's still 15 to 1. So, even though they might be... You know, most broker-dealers might be letting you trade 4 to 1, that's still a fraction of what leverage they can use with their own money. Now, what the rules are as far as them extending further credit to you

• 7:39Speaker 00

  without having a license, I have to go do a little more research on that. But there are people who have a phenomenal sense of timing and have developed such a way of trading that they can trade with large positions, concentrated positions, because they know, you know, they have a good sense of accuracy, good sense of timing, a lot of experience, and they will pound into a position and put on four or five times what the actual net capital in the account is to trade that position. However, they might only be giving it, say, 2 or 3 cents of risk. That's how good their timing is. You know, maybe a nickel, so to give you an idea. You can get there. I believe you can get there.

• 8:24Speaker 00

  It'll come with practice. It'll come with your doing it. I don't think you can sit and watch how-to videos and infuse yourself any more than I can paint something like this by just watching old videos of, I don't know, Gerhard Richter or someone who was doing gestural abstraction. You have to actually do it. You have to mix the paint. You have to add your layers. You have to, you know, gesso... This is gesso on the substrate. So if you do it, do it with 5 or 10 shares. This is the key. If you want to really be one of those bigger day traders who can throw around size, don't start with the size. Start with something that's humble and digestible and buy 5 or 10 shares or something.

• 9:09Speaker 00

  Forget how much money you could make. It's more to... It's like those things, you know, there's... Think about it as just honing your skill. You're just trying to get better so that you can scale up. Keep track of how you do it. But this is the key part of money management. Like, once you have an idea that your numbers are good and that you can trust yourself, then you can scale and get bigger. And I know people who do that, and there's nothing wrong with it. But they didn't just go there and say, like, "Okay, this is what I want to do." They set it as a goal, but then they had to practice it. And when you do it with real money, you can see it. You probably need a level 2. But the money management part becomes a big deal

• 9:53Speaker 00

  because then it's like, okay, say you're trading, say, even 2 to 1. Say you have 25K and you want to trade it like 50. So you buy 1,000 shares of a $50 stock. And, you know, your sense of timing is very, very strong. You have... Obviously, you could take that home under Regulation T, or you could cut it in half and get off the leverage, right? Because you're going to have to pay a margin balance. There's interest on that.

• 10:18Speaker 00

  And it's probably not cheap. So cut that in half or cut a good chunk of it away and, you know, make your money with the leverage, but then delever, you know, at very key inflection points. Know those inflection points and know where the weakness comes because, again, with leverage, now, you know, the sword is cutting both ways anyway, but with leverage, it's enhanced. And we talked about position sizing yesterday. Trading big positions on margin can leave deeper gashes, and that can really shake you up. So be careful with that. That's a really good place to try the simulator and think if you can especially look and see and trade reversals. Those would be great opportunities for you to, you know, get going with that kind of stuff.

• 11:03Speaker 00

  So we'll talk about this more going forward. Check out the link below for the cohort. I wish you a great weekend. Keep the comments and the questions coming, and I'll see you Monday.