Sample chapter from

BETTER TRADING

Money and Risk Management

Daryl Guppy © This extract copyright 2001.

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        Most of us dream of having a love affair with money. For many years I resisted this temptation. I subscribed to the view that money was made round to go around. No sooner did a pay cheque arrive than it was gone, spent on entertainment, recreation and daily necessities.

        It was a frugal farmer’s wife who introduced me to the idea that money is made flat to stack. She believed every spare dollar note should be stacked away in a bank account. It took ten years for the idea to sink in before I started banking spare cash instead of spending it.

        It took a little longer to discover how money multiplies when it is stacked in just the right place. In the financial market it has a real opportunity to multiply.

        Correct stacking turns good trades into fabulous winners. Just cutting losses quickly is not enough to turn trading income into wealth. Money management techniques magnify returns but most methods apply to institutions and funds.

        Private traders are most often undercapitalized. We simply do not have enough money in the market to achieve the diversity, the economy of scale, or the size required to effectively apply many institutional money management techniques. Some private traders turn to derivatives, futures, options and warrants markets to achieve the leverage they need to magnify returns. Often they also unwittingly magnify the risk in a trade.

        This book examines a small selection of money management methods suitable for private traders. Most of my income comes from trading and these are the methods I use. They are not perfect although they are battle scarred. I offer them as some possibilities you might like to consider for your own journey from Trader Average to Trader Success. You may disagree with some of the solutions, but the general principle remains unchallenged. We grow capital by managing losses carefully. We do not grow capital by concentrating on profit.

        We enlist the help of four typical traders throughout the book to demonstrate various techniques. They are Traders Novice, Average, Success and Superstar. There is a little of each of them in every reader. The difference between Trader Novice and Trader Superstar comes from the way they understand risk. It does not only come from the amount of money they have, from dramatically improved skill levels or from the number and size of winning trades. Each of these factors contributes to their performance, but at heart the differences come from the way they manage risk.

        The distribution of returns from successful trades remains generally constant for each of these traders. Most trades deliver average returns of around 10%. We get the analysis correct but the trade does not perform well. The icing on the cake comes from just one or two exceptional trades where everything comes together. The trade analysis is correct, price leverage helps increase profits, and the exit timing is excellent.

 
        We cannot identify these exceptional trades in advance. When they happen we need to recognize them quickly. Then we use one of several money management strategies to boost the trade performance and its contribution to our annual trading results. Trader Novice does not understand these skills, so from the same distribution curve, he adds perhaps 10% to his portfolio capital during the year. Trader Superstar has a similar distribution curve, but he uses money management to collect a far superior return on portfolio capital. Understanding these methods is the subject of this book.

        We do not intend to tell you there is only one way to approach money management issues. There are many different approaches suitable for small accounts. Our objective is to show you some of the ways trading performance is boosted by better money management and by a better understanding of risk and its impact on your portfolio. Ultimately you may choose to select just one or two, if any, of these techniques. The choice is yours and the choice is as individual as every trader.

        Our focus is on the stock, or equity market. This is the bread and butter of trading. How we manage risk decides how well we trade. Money management is the key to better trading. This book introduces you to a selection of techniques suitable for traders with small accounts. It shows you some ways to stack your trading returns so they multiply. Please read on and prosper.