Hi, this is your Trader of Stocks. In this definite guide we will look beyond superficial money management and provide proven and in-depth techniques to lock-in profits, control risk, circumvent psychological pitfalls and hone your statistical edge.
If you plan to leave the rat race one day you might find the actionable techniques in this guide quite helpful. After all, getting money management right is a major building block in the pyramid of stock trading success according to my believe. Getting it right from the start can push you into the realm of net profitability even if you haven’t been able to spend the thousands of hours needed to reach mastery in chart reading & stock handling yet.
Following and adopting some or all of the hard learned ideas/techniques presented here has the potential to speed up your trading journey like nothing else. In any case it will surely eliminate all of the remaining guess work left in your current approach.
The 4 Jedi Mind Tricks solve specific psychological issues which plague many traders these days. They all follow some proven ZEN principles and alter they way you think about certain aspects of the game. They work by either changing your perspective or by helping you dodge useless information.
In general they help you unclutter your fragile trading mind.
Succesful trading is a mix of science and art. In this article and my other articles on money management you are going to find out that I treat the topic rather like science. However you’ll also see that I was not able to solve all of my problems with the help of my scientific education alone.
Money Management Rule #1: Percentages!
Using absolute values doesn’t make much sense when you work with numbers which can span several orders of magnitude such as account balances or asset prices. A negative real world example would be the headline ‘fastest 1000 point advance in the history of the Dow Jones’, which used to pop up regularly over the last couple years. 1000 points in 2009 translated to a 15% move, in 2020 it was 5% and now in 2021 it’s 2.9%. You can see that those 1k steps aren’t that impressive anymore but they seem to be good enough to create catchy headlines. Just one of the reasons why I don’t read the financial news that much.
Anyway, so you have to work with percentages in trading out of necessity. When it comes to portfolio or money management this has definite psychological advantages as well. When done right you can trade without having to face your absolute account balance at all. This is a huge emotional advantage that allows you to put your complete focus on the process itself and not the outcome. The outcome for us traders is ultimately the equity curve. We all want it to make fresh all times highs but it doesn’t help when we stalk it.
Here is my efficient portfolio work-flow using only percentages:
Initial step is obviously to find a stock you want to trade. After that you…
- Define a logical stop level on the chart. Refer to this article on how this is done in a logical and sensible way.
- Calculate your position size % with the help of the latest price of the stock, the price of the stop and the maximum risk % you are willing to lose on any given trade. (How to find your maximum risk % per trade)
- Make sure that the obtained position size % doesn’t exceed your maximum size. (How to find your max position size %)
- You now enter the position size % into your money management tool and it will tell you how many shares to buy/sell. For this to work you need to, either have a connection to your broker (i.e., API) in order to fetch your current account balance or use a system to calculate your account balance in the background. I have an excel spreadsheet which does the latter.
- Next you place the actual trade with your broker (don’t check the account balance!) and put up the trade in your tool.
- For monitoring and analysis purposes you track the initial position size %, initial risk %, current position size %, current risk %, profit/loss as % of total account balance and so on. But more on this in chapter 2 below.
If you follow such a workflow you don’t have to be actively aware of your account balance at all. This truly helps to deal with the nasty phenomenon called ‘performance anxiety‘. More on this in the respective chapter below (Chapter 4. Overcome psychological & behavioural obstacles).
Efficient Trade Tracking
Trades are standalone and rather independet events triggered by a top down approach, meaning that you decide to trade a stock because of the chart action at hand and not due to some portfolio related parameter. The stock chart -or whatever indicator/method you use- will tell you when a good risk/reward situation is present! Your account balance or your exposure should not be a factor in this. Of course you can’t take on more trades when once your fully invested but other than that it’s stocks first. You shouldn’t look hard for stocks either just because you have cash left to invest. Better put yourself in a position to find trades all year round by following a solid and effortless screening routine. Read some more about my approach to screening here.
Once you made your stock purchase you measure the profit or loss of the trade as a percentage of your account balance (P/L %) at the then current level (Account balance when you entered the trade). There are modifications to this as explained in chapter 4 (How to account for open trading profits).
The stop loss of your individual trade translates to an initial % risk based on the initial position size % and the account balance when you opened the trade.
So what’s that initial position?
Well it’s the positon you establish before the stock makes a significant move, such as reaching a substantial portion of the desired risk multiple. This initial position could consist of a single trade or multiple stock purchases, depending on how much you ‘work’ the entry to get a good average price. Doing this is daily business when engaging with tight pullbacks, which I like to do a lot. Such setups give you plenty of time to establish a solid position over hours or even days sometimes.
So your portfolio tool must have the capability to mark subsequent trades under the same ticker symbol as part of an initial position. You need this functionality to be able to pinpoint the risk you took in the heat of the moment when you entered the trade. It is very important to always be aware of the initial portfolio risk, even for the trades who later turn out to be winners. If you don’t have this functionality somewhat automated, you have to write the initial % risk down! And please don’t move your stops to breakeven trying to erase any high initial risk from your view. Doing such things would is a flawed approach.
With the initial % risk and the P/L % you can calculate your risk multiple. The risk multiple is simply the outcome of your trade ( P/L %) divided by the initial % risk. Depending on your win rate you do need to reach a specific average risk multiple in order to trade your system profitable as shown in graph above. Read more about this in my article about win rate and maximum risk.
The important tracking parameters (beside direction and holding period) for each portfolio position (read: trade) are as follows:
- Initial % risk
- Intial % position size
- R-Multiple of the trade
- The fees/commision of the trade
That’s it! Nothing more and nothing less. Fees and commission are important as they typically provide a hard lower limit for your holding period. Or in other words, the fees/commission as a percentage of profits will tell you if you cannibalize your own profits (bye bye day trading).
Years back I also calculated the percentage of peak open profits I was able to secure, but as it turned out, that tracking parameter is quite harmful. It would tell you that a good trade is bad just because you gave up open profits. Such details are meaningless.
Any trade which either hits your stop or your desired risk-muliple is a good trade. Bad trades are those in which you lose more than your predetermined maximum % risk or where you move your stop to breakeven before it was able to hit the desired risk-multiple. All other trades are good ones, even if that means to let a +50% portfolio gain fall back to +10%. Giving back a lot of open profits feels bad and sometimes requires a brief “emotional digestion period” but in the greater scheme of things such trades are good ones for sure.
Laser Like Focus on Risk
Succesful trading is all about controlling the risk you take with each individual trade. You must turn into a stop loss machine where you execute your stop losses without second guessing once you lost your prefedined maximum risk on any given trade. There are no such things as paper losses! All losses are real! Over time the frequency and magnitude of wins should improve and turn your system into a profitable one.
You can’t afford to have larger than planned losses on a frequent basis. A few can be absorbed but if they show up regularly and at the wrong moment, they will quickly render your system unprofitable.
But can I prevent larger than planned single trade losses from happening at all, and if so how?
Short answer, yes you can.
Long answer: You must stick to proven protection rules. I do have my own -hard learned- rule set which I follow and I rarely experience substantially larger than planned losses in my trading at all. The last time it happened was in 2019. Back there I lost three times my maximum % risk on a trade. If you stick to proven rules it simply won’t happen anymore. Rules include: No gambling on earnings, no short selling of potential buy-out candidates, no overexposure to biotechs/chinese companies and so on.
You can read more about my proven set of protection rules here. Follow them or create your own list based on your own history of failures & lessons learned. However I am pretty confident that I am no special snowflake and that my list will work for others as well.
Wonder how to determine a reasonable maximum risk per trade? Well you can use the following calculator:
It will provide you with a reasonable max % risk based on your win rate, maximum acceptable drawdown and trading frequency (opportunities). It is based on the probability of losing streaks but the results are valid for random trade outcomes as well. It simply provides you with a solid practical value to work with. No more guessing or using oversimplified and meaningless fixed values such as the infamous 2% rule.
It simply works!
If you have solid statistics for each individual setup at hand you can even go a step further and slightly increase the risk and thus the position size and profit potential on the setups with the highest win rate. However your average % risk per trade should be roughly what the calculator above spits out.
How to Account for Open Trading Profits
As explained above, profitable trading is a lot about the risk you took in the heat of the moment. This % risk is based on your account balance at exactly the moment when you entered the trade.
But should you really use your actual account balance to calculate your position size and risk? After all any open trade which has unrealized profits (read: paper profits) can fluctuate and put your account balance in a constant state of flux.
Here is a worst case scenario to illustrate the potential issues:
Imagine you are doing very well and your account makes fresh all time highs constantly as your winning position(s) continue to resolve to the upside. Life’s good and the market is going your way. It then pulls back a little and you pull the trigger on 4 awesome fresh setups (read: you failed to realize that they are laggards) at once. The next day your leaders have very bad breaks off the highs thus triggering some red flag exits. Suddenly you lost a substantial portion of your open profits and your actual account balance. The actual position size % of the 4 fresh money trades is now much larger then the initial position size % due to a -now smaller- overall account balance. They are not so awesome anymore and the properly set stop loss orders, once triggered, will most likely exceed the maximum risk % you are willing to take.
Sounds familiar? We have all been there!
Here are three potential solutions for this dilemma:
A) The conservative approach:
You don’t use your overall account balance anymore when calcuating your position sizes but your account balance excluding all open profits and including all open losses. Simple as that. This dampens the compounding potential a little but can work very well for traders who tend to take on too much risk at the wrong time.
B) The sensible approach:
You set protection stops (not to be confused with trailing stops) in your open trades. The logic behind placing protection stops is opposite to stop losses. A protection stop has to protect you from flash crashes in individual stocks or the market as a whole. For this to work, you place them way down the chart so that a normal price move won’t trigger it. You also place it in a way that, if price does reach that level, your order will get filled right away and ahead of the crowd.
But how do I place a protection stop in such a way that it gets triggered & filled quickly in the case of emergency?
Well, you place it above logical support and not below it. It’s basically like placing a very weak stop loss right above support.
This protection stop is not meant to be triggered. You should exit trades based on real time price and volume action in almost all cases. The protection stop is just an insurance.
So you place protection stops for all open trades and calculate the account balance excluding any open gains above these protection stops. You then go on and use that “sensible” account balance for the calculation of the position size % and stop loss % of fresh money buys.
C) You simply try to be have better trigger control (read: don’t take on too many fresh money buys at once).
This brings us to the concept of open heat.
How to Control Overall Portfolio Risk (Open Heat)
Open heat is a neat concept which helps you control the worst case drawdown potential when you have been trigger happy and initiated too many fresh trades at once. Your current open heat tells you how much you would lose if all recent trades hit their stop losses simultaneously.
Open heat is simply the sum of the initial % risk of each trade which is not up by your desired risk multiple yet. Recall that you should never let a trade -which was up your desired goal risk multiple- turn into a loss again.
Open heat must not exceed a specific overall % of your account size. Again you can use your actual, conservative or sensible account size for this (see chapter above: How to Account for Open Trading Profits).
A good practical value for open heat is 4% to 5%. I am stuck with this range for years now and don’t take on fresh trades if they would push me over this threshold. Having bad timing and losing 4% at once is bad, but much better than losing 10% or even more (ask me how I know that).
In practice, large drawdown are created as follows: Market looks great and you buy into fresh setups. Market then rolls over and your multi week/months leaders see their open profits evaporate quickly. On top of that your recent buys hit their stops simultaneously. You are now on the defense and begin to exit long term winners prematurely to ease the emotional pressure and to prevent any further harm to your account.
Controlling open heat will prevent this scenario from spiralling into a true nightmare.
Overcome Psychological & Behavioural Obstacles
Over the years I came up with some unique solutions to overcome many typical obstacles to trading success. Some techniques might be novel others might be not. What they do have in common is that they have all been “enabling” techniques for me. Without them I would not be able to trade as diciplined, detached and profitable as I do now!
Novice traders tend to mistakenly label the concepts below as trivial but I assure you that this coouldn’t been further from the truth. Traders (even seasoned ones who should know better) generally tend to neglect phsychological & behavioural techniques in favour of more tangible concepts. Well, the techniques outlined below actually made psychology based techniques tangible for me.
Mind Trick #1: Treat add-ons as fresh money trades
Once a trade exceeded my desired risk multiple I try to think less, sit tight and only react to the price and volume action of the stock at hand. By that time the trade most likely matured from a swing into a position trade already. Position size is typically less than my max regular position size at that point as I already scaled-out some to lock in my R-multiple. During this phase I monitor the stock for a proper setup with the idea to ‘refill’ my position back to the regular size. It’s important to realize that I don’t use second tier add-on entries but rather insist on a proper setup which would also be a valid regular fresh money buy.
Refilling back to your regular size would be the conservative approach.
However I also experimented with a more aggressive technique. The aggressive way would be to treat any new setup as a fresh individual trade on top of the remaining core position. The main idea is to set a proper stop loss which is only active for this recent trade but has no meaning for the core position. Once the stop is triggered without it being a red flag, I would go on and only exit the size entered at the last proper setup, while keeping the core position intact. Only if the stop loss violation constitutes a major red flag do I close the entire position. As a result of this aggressive technique I allow the overall position in a stock to exceed my normal max position size by up to 50%. If my normal size is 17% I would allow it to go as high as 25% sometimes. I also track those trades individually in order to collect data on them.
Keep in mind that the conservative “refill” approach mentioned first comes with a built-in pyramiding effect already. Filling up your regular position size in a winning trade means that the position size grows with your account size. The degree of this pyramiding effect obviously depends on your account growth and how you calculate position size % (refer to chapter 4: How to account for open profits).
Mind Trick #2: Secure your base profit/risk multiple via scale-outs
Once your trade is up the desired risk multiple you should take measures to not let it turn into a loss again.
Here are some related Q&A entries:
- Do you believe in moving stops to breakeven or do you let the trade play out unless there’s a ‘’red flag’’?
My practical approach to secure or lock in wins is as follows:
Once a trade is up at least 3R (R = Risk multiple) I will run for the exit once it drops back to below 2.6R. This is a hard coded portfolio driven sell rule. In order to reduce the odds of this from happening, I do seek partial scale-outs into strength. This means trying to exit part of the position once the trade is up by your desired risk-multiple. Syncing this with the actual chart action is delicate but more often than not my hard coded 10% scale-out rule in combination with major PLL levels or clothesline hits do allow logical and reasonable scale-outs when you need them. This is what I call “Lock in the Trade”.
You basically fortify the trade and secure a baseline profit needed to run your system profitable as shown in the graph above. But if the stock continues to go higher you would still be on board with meaningful skin in the trade.
Once you scaled-out some (enough) around your desired 3R risk-multiple, it is much more easy to stick to the trade as the stock now needs to drop much more before hitting the 2.6R threshold due to a now reduced position size.
Scaling out into strength instead of weakness is the magic formula here.
Once this is done you simply sit tight aiming for the long term move. Keep in mind that I ignore any profits gathered above 3R in my expectancy calculation. This is what I call the capped portfolio approach! (More on this in the following chapter). 3R would be the base system in this case. However if your win rate is different (you need to make an educated guess in the beginning) you have to go with a different risk-multiple according to the graph in chapter 2: Efficient Trade Tracking.
According to the graph above a 50% win rate translates to 1R. With a win rate of just 20% you need to aim for profits which are at least 4 times your initial % risk (4R system). A win here is referring to a trade exited at the goal risk multiple. Scratch wins as a result of moving your stock to breakeven don’t count!
Mind Trick #3: Cap emotions via a capped portfolio approach
By now you know that I follow an approach where I only care about the profitability of a base system depending on my individual goal R-multiple. However I do allow my actual trades to make progress beyond this goal R-multiple and only ignore them in the actual calculation (see Jedi Mind Trick #1). Despite it being a simple technique, it pretty much lifted my trading to a complete new level in terms of profit and drawdown consistency in 2017.
The capped portfolio approach is extremely effective and solves a myriad of common psychological pitfalls, at least it did for me. It will help you stick to your rules and give you great peace of mind.
Mind Trick #4: Cope with performance anxiety by removing the price tag
Performance anxiety rears it’s ugly head whenever you shift your focus away from performing in the present over to caring about the future outcome or result. The ‘result’ for us traders is obviously our equity curve!
Performance anxiety is the opposite of trading in the zone!
As a trader you want to focus on the process or ‘live the process’ so to speak. Performance anxiety will render this task impossible.
I can’t speak for you but my experience during my early market years made clear that performance anxiety is a major obstacle to trading success. Once you start to alter your trading based on your account balance performance will suffer. At least short term!
Performance anxiety works in both ways by the way.
Performance anxiety during weak spells: When you face a regular equity draw down after a good market period you suddenly start to move stops to breakeven or realize profits too quickly in order to get rid of this ugly -but normal- pull back in your equity curve. This normally makes things worse by triggering overtrading with the potential to quickly deepen your drawdown beyond your comfort level. Once you got your composure back you start to follow your rules again in an attempt to climb out of the larger then desired account hole.
We have all been there!
Performance anxiety can also strike when you are doing exceptionally well for a while and even scored some big wins recently. You are thrilled and start to watch your equity curve like a hawk being in pure awe of it’s ability to go vertical, not realizing that the market environment played an important role in all this. You decide to increase your position sizes hencing increasing your risk as well because you feel invincible and really want to push your luck. Once the market environment is shifting you’ll likely won’t be able to fall back to your regular process in time and suffer a larger than necessary drawdown in the process.
Solution: Ignore your account balance altogether and simply work with a statistically calculated expectancy based on your trading history. Try to keep that calculated expectancy green throughout the year!
As long as the expectancy is green you just ‘trade your process’ and only check your account balance once a quarter or so. Ideally this calculated expectancy only represents a basic system based on win-rate and risk-multiple. It also helps to statistically verify that your calculated expectancy is real. More on this in the following chapters.
Build Confidence via Statistics
Statistical tools are irreplacable for decision making in the scientific and corperate world. While big data and neural networks are a big deal nowadays, classical statistical methods are more than suffcient to justifiably build or destroy confidence in a trading system.
But why do I need this? I already calculate the expectancy of my system and it’s all good!
Well, this is great but can you really tell if your expectancy is real or not?
Imagine you just made 20 trades and your expectancy is postive. At this point it would be premature to state that the system is profitable due to a small number of trades. It could be that those 20 trades have all been made during a favourable market period and thus represent only the right tail of a standard distribution with a mean value of zero or even negative. The distribution of your trade outcomes when following a valid risk multiple system other than 1R will be skewed and should not resemble a bell curve. Accounting for this however would require more complicated math including various dataset transformation and all that.
For us traders it is fine to assume that the outcome has a normal distribution in oder to apply a standard T-test procedure. I applied some transformations to turn my log-normal distributed outcome histogram into a normal distributed one and the result was pretty much the same. The resulting probability is expressed as a percentage.
This percentage will tell you how likely it is that your calculated expectany is either real or just part of the aforementioned normal distribution with a mean value of zero (read: not profitable).
No matter how good your trading goes, you will need more than a handful of trades to reach the desired >99.9%.
The procedure to calculate the probability is as follows:
- Have a list of your trade outcomes as a % of your account balance (P/L %)
- Calculate the standard deviation of the P/L % dataset
- Calculate the expectancy of your trade outcomes
- Know your number of trades
- Calculate the T-score according to the equation below
- With the help of the T-score you can look up the p-value aka probability from an online table or online calculator. You can also calculate the p-value for a given T-score and trade count in Excel via the TDIST dunction (It’s called TVERT in the German version).
T-score = (Expectancy / Standard Deviation) * squareroot (number of trades)
Goal is to get the probability (p-value) to >99.9%. Once you reach this number you can trust your calculated expectancy.
Is your probability >99.9 and calculated expectancy positive?
Congratulations! You succeeded in creating a working trading system for you. That’s one hell of an accomplishment.
Identify and weed out unprofitable setups
I calculate expectancy and probability for all trades but also individually for each proper setup I employ. Doing this allows me to identify and get rid of bad setups which dilute performamce. When a setup doesn’t work well I simply let it go. Examples of the past are base breakouts and 50d MA bounces. The undercut and rally setup is also not working very well statistically, but it has the advantage of building some long exposure early in a potential rally and thus helps me dodge the FOMO (fear of missing out). I also trade fresh setups with half the normal size until I was able to collect enough data to calculate the metrics.
I know that doing all this is a big hurdle for many. However, the reward is a major gain in confidence in your trading system. Or the opposite if your system is weak. In any case you won’t waste precious time trying to make a bad system work.
Monitor and Intervene
In my everyday trading I monitor my portfolio based on given metrics and only intervene when needed.
In the following I will explain the various metrics I monitor. I calculate those metrics as an average over all trades but also as an rolling average for the last 10 trades to be able to see anomalies at a glance in order to be able to intervene right away. I used to go with a 20 trade rolling average but as my trading frequency went down over the years I reduced it to just 10.
The first three are the major metrics. Goal is to have them all green all the time in my traffic light system.
- Expectancy: Yearly projected return with winners capped at 3 times the goal risk. Positive = good; negative = bad
- Probability: Probability that the expectancy is statistically significant : <95% = bad, 99% = ok, 99.9% = good. Read more about the probability metric in the chapter above.
- Pain/Gain ratio: Gain to Pain Ratio: <1 = bad; 1 = ok; >2 = good (best real world performance metric)
The remaining parameters are minor metrics. Minor metrics should be green but orange is ok when the three major ones are all green!
- Initial position size %: Average initial position size of all trades. Above 30% is overtrading even for smaller account. Theshold is lower for larger accounts.
- Trades/week: Trades per week extrapolated for the whole year. Above 4 is an indicator for overtrading according to my experience and I traded through many market cycles already.
- Fees as % of account balance: Commission as a percentage of the account balance projected for a full year (Goal: <10%)
- Average risk % per trade: Loss % of actual losing trades and the initial risk % of winning trades.
- R-multiple of winners: Average profit/risk ratio of winners. Wins capped at +6 % for calculation to lessen impact of big wins.
- 3R win rate: Win rate considering only proper 3R wins
Once a major metric is orange or red I try to get it back to green asap. Simple as that.
Last Words and Excel Template Download
Fellow traders that’s it.
You just read about all portfolio related things I do day in and day out in order to come out ahead. Excel is my best friend but we neverthelss work on putting all this stuff into an online app/website right now as we speak. I trade more and more from mobile these days and therefore don’t have access to Microsoft Excel as much as I used to.
But if you have Excel or a similar tool I strongly urge you to give it a shot right now. I am very confident that you will reach a new level in your trading quickly, just like I did. The tools have actually been that powerful for me.
Feel free to download my Excel Portfolio Template right here.
But be aware that it wasn’t created with a wide audience in mind.
More power to you!