Money Management, Part 1

There are some common mistakes I've seen traders make in the area of money management. First, let's understand what money management is all about.

Money management overlaps with risk, trade, business, and personal management, yet it has many aspects that make it unique, distinctly different from all of the other areas of management. In this chapter we want to examine some areas of money management that seem to involve mental quirks leading to costly mistakes.

LISTENING TO OPINION

Kim has entered a short position in crude oil after carefully studying as many factors as she could reasonably include while making her decision to trade. She has entered the trade because her study of the underlying fundamentals has her convinced that crude oil prices must soon begin to fall. Then Kim turns on her television set and begins to watch one of the financial news stations. An "expert" in crude oil is being interviewed. He begins to talk about how crude oil inventories are almost certain to drop this year because oil companies are not doing as much exploration as they have in previous years. Kim listens intently to what he has to say and then begins to doubt her decision about the trade she has entered. The more she thinks about it, the more panicky she becomes. She considers abandoning her position even though she will end up with a loss. The fact that an "expert" has decided something else completely shakes her confidence. She exits the trade intraday and takes a $400 loss. Prices have not come near her protective stop, which was $700 away from her entry. The market never moves sufficiently far to have taken out her stop. By the end of the day, her crude oil futures have made a new high, and in the following days explodes into a genuine bull market. Instead of a magnificent win, Kim has a loss. The loss is more than money, she has lost confidence in herself.

What should be done?

You should set your own trading guidelines and trade what you see. Forget about opinion, your own and especially that of others. Unless you are one of a very rare breed whose opinions are sufficiently good for trading, do not trade on them.

Make an evaluation based on the facts you have and then go with the trade. Just be sure you have a strategy for extricating yourself before losses become big. Had Kim stayed with her original strategy and stop placement, she would have ended up a happy winner instead of a regretful loser.

TAKING TOO BIG A BITE

Biting off more than can be chewed is a weakness of many traders. This form of over trading derives from greed and failing to have clearly defined trading objectives. Trading only to "make money" is not sufficient.

Pete has sold short T-Bonds and is now ahead by a full point. He notes that he is making money on his trade. Feeling very confident and thinking it would be smart to be diversified, he enters a long position in silver futures, and also sells short Call options of wheat which he is sure is headed down. Almost as soon he is in the market, wheat prices explode upward and his Calls are in trouble. Pete buys back the losing short Calls and sells additional Calls on a two-for-one basis at a higher strike price. At the end of the day he looks at other positions. Silver had an intraday reversal leaving a spiked bottom as they close at the high of the day. The T-Bonds have made an inside day, but to Pete they suddenly look weak, he is down a few ticks. At the end of the day, he finds that most of the money he had made on his short T-Bonds was used to buy back the short wheat Call options. He covered those and now has additional premium in his account, but he also has additional risk, and is short Calls in a rising market - not an enviable position. Moreover, he is now worried about his long silver futures based on the fact that silver closed at its lows on what seems to be a genuine reversal. To further aggravate the situation, he has lost confidence in himself. What was once a happy, simple, winning silver long, has now become an ugly, confusing mess, and Pete has a good chance of ending up a loser on all three trades. If Pete keeps over-trading in this fashion, he could end up like the poor fellow in the picture.

What should be done?

Break every trade into definitive goals. Make sure you achieve those goals before adding other positions. Even with a single short sale of the T-Bonds, Pete could have set himself a goal for the trade. One or two full points might have been all he needed to satisfactorily retire that trade as a winner. Then he could have made his trading decision for an additional position. There are very few traders who can successfully manage multiple positions in a variety of markets.

OVERCONFIDENCE

Overconfidence is a particular kind of trap that springs shut when people have or think they have special information or personal experience, no matter how limited. That's why small traders get hurt trading on no more information than "hot-tips."

Tim is a farmer. He raises hogs and purchases huge amounts of feed to provide for his hogs. Tim has a large farming operation which is quite profitable. He takes 250 hogs a week to market. Because of a steady flow of hogs from his operation to the market, Tim has no need to hedge his hog business because he is able to dollar average the prices he gets for them. But Tim does want to indirectly reduce the cost of the feed he has to buy, so he purchases soy meal futures. Tim listens to weather and farm reports all day long. He attends meetings of other farmers, and tries to gather all the information he can that might help him be more profitable. But Tim has a major problem, called tunnel vision. When he looks out at the grain fields in the area where he lives, whatever he sees there he extrapolates to the whole world.

In other words, if Tim sees that the surrounding fields are dry, he suspects that all fields everywhere must also be dry. One year Tim witnessed a local drought. He checked with all the local farmers and they said they were truly experiencing drought conditions. He looked at the news on his data feed, and sure enough it said that there was a drought in his area. In fact, the entire state where Tim raises his hogs was undergoing drought.

Tim wasn't too concerned about his own feed bins. He had plenty of it in his silos from previous bumper crop years. Tim decided to be piggish and speculate on what he considered to be inside information. He called his broker and bought heavily into soy meal futures. Tim was confident. He was sure that soy meal prices would explode upward some time soon, and that he was going to make himself a small fortune. Tim's greed may have turned him into a hog. However, the futures he purchased started moving down and the value of his investment began to shrink markedly. What Tim failed to do was to have a broader perspective. Everywhere else that grains were grown, farmers were experiencing rain in due season. The drought was localized almost entirely within the state in which Tim did his hog raising. Tim lost because he was confident in the limited knowledge he had.

What should be done?

We all need to broaden our horizons. We need a humble attitude relative to the markets. We can never afford to wallow in overconfidence in what we perceive as special knowledge. A trader can never afford to let his guard down. Tim thought he knew something that others hadn't yet caught onto. In so doing, Tim made another mistake as well. He heard only what he wanted to hear.

HEARING WHAT YOU WANT TO HEAR - SEEING WHAT YOU WANT TO SEE

Marketers call this preferential bias. Preferential bias exists among traders. Once they develop a preference for a trade, they often distort additional information to support their view. This is why an otherwise conscientious trader may choose to ignore what the market is really doing. We've seen traders convince themselves that a market was going up when, in fact, it was in an established downtrend. We've seen traders poll their friends and brokers until they obtained an opinion that agreed with their own, and then enter a trade based upon that opinion.

A student of ours, Fran and her husband, John, decided they wanted to go to live in the Missouri Ozarks. Everyone told them that there was no way for them to make a living there.

Everyone they asked advised them not to do it.

Finally, a minister in the Church they proposed to attend told them that they were to serve there. Out of twenty or thirty people they asked, that minister was the only one who told them to come. Of course, it was exactly what they wanted to hear. They sold their home and most of their possessions accumulated over a lifetime. They moved to the Ozarks and went broke within a year. They had to leave and begin all over again. John, who had been semi-retired, now had to find a job. So did Fran. She had to give up a promising start as a trader to go out to put food on the table.

What should be done?

Look at each trade objectively. Do not allow yourself to become married to your opinion. Learn to recognize the difference between what you see, what you feel, and what you think. Then, throw out what you think. Lock out the input of others once you have made up your mind. Don't let your broker tell you what you want to hear. Never ask your broker, your friends, or your relatives for an opinion. Turn off your TV or radio, you don't need to see or hear what they have to say. Take all indicators off your chart and just look at the price bars. If you still see a trade there, then go for it.

To be continued in Article Part 2 about Money Management!

Joe Ross
Trading Educators Inc

ABOUT JOE ROSS:
Joe Ross has been trading for more than 47 years, and is a well known Master Trader. He has survived all the up and downs of the markets because of his adaptable trading style, using a low-risk approach that produces consistent profits.

Joe is the creator of the Ross hook, and has set new standards for low-risk trading with his concept of "The Law of Charts?." Joe was a private trader for most of his life. In the mid 80's he shift his focus and decided to share his knowledge. After his recovery, he founded Trading Educators in 1988 to teach aspiring traders how to make profits using his trading approach. He has written 12 major books on trading. All of them have become classics and have been translated into many different languages.

Joe holds a Bachelor of Science degree in Business Administration from the University of California at Los Angeles. He did his Masters work in Computer Sciences at the George Washington University extension in Norfolk, VA. Joe still tutors, teaches, writes, and trades regularly. Joe is still an active and integral part of Trading Educators.

Adaptation to the Realities of the Market

Do you think adaptation to the realities of the market is the most important thing?

Many times in the past I've written about the need to adapt, the need to be able to change your behavior relative to the market because the markets are ever changing. I've stated that mechanical systems may be workable, but for only a short time relative to the life of markets. You must learn to trade what you see and to understand what you see on a chart.

When I first began trading there was no such things as futures contracts for foreign currencies. Why didn't they exist? Because there was no need for them! In the 1970's all that changed when the US dollar went off the gold standard and began to float against other currencies. Following that, the Chicago Mercantile Exchange began to create currency futures to provide a place where currency traders could hedge the risks associated with dealing in foreign currencies. Some of these risks are direct and some are indirect. Direct risk is involved for those who deal directly in foreign exchange. Indirect risk involves companies who export or import and receive payments or make payments in the currency of another country. Ever since currency futures were created, they have been in a state of flux. More recently, for purposes of futures trading, currency gyrations have centered on a massive move away from currency futures to more direct trading in the forex markets. Currency futures, while maintaining their volume and open interest figures, are actually less liquid than they had been previously. Volume and open interest do not reveal the picture of what is happening in the currency futures pits. Volume and open interest levels are being maintained by fewer and fewer futures traders.

In the period from 1992 to the present, we've witnessed currency futures moving from "red-hot" to "cool" and now hot again insofar as speculators are concerned. Foreign exchange, which in 1992 was one of the hottest plays, first turned dull and then back again to exciting. That this has happened can be seen in areas of which most futures traders are ignorant. Five years ago foreign currency traders were being paid huge salaries and anyone with a track record could virtually name his price. Following that, currency traders were no longer in great demand. Now, again, there is a huge demand for successful currency traders. Currency futures are but a small representation of the $1.5 trillion dollar foreign exchange market. Professional currency traders use forex, forwarding contracts, derivatives of all kinds, and the futures pits, to deploy their various trading and hedging strategies. Looking at only the futures is like the blind man trying to tell what an elephant is like by feeling only the tusks.

In past years, foreign exchange desks at banks, insurance companies, brokers, and other institutions were seen closing down and firing hundreds of employees. Today, they are again looking for currency traders. In the 1990s, Midland Bank closed its foreign New York office laying off dozens of people. Frankfurt Bank had pulled out of New York and Tokyo closed down its foreign exchange desk. At that time, the world's largest foreign exchange trader was Citicorp. In the D-Mark alone, they shrank from 39 traders working at 17 different locations around the world to 4 D-Mark traders all working in one room. Keep in mind that these were traders who had been to a greater or lesser extent using the currency futures. The result at that time was that there were fewer big fluctuations in the currency futures than there once were and therefore much less profit.

However, today, just the opposite is happening. Central banks are presently making much greater interventions in the currency markets. They have stopped publishing targeted exchange rates. Such action by the central banks leaves currency speculators at a loss for what to do, and the result has been a huge surge in forex trading. Because today forex brokers abound and are actively marketing the idea of currency speculation, it is having a profound effect on the foreign exchange planning of individuals, companies, and nations.

If some day the major currencies would be the US dollar, the J-Yen and the euro, who would need thousands of traders to trade them? There would be far fewer currency misalignments to provide a basis for trading. But that is not the way the world is moving. The picture I just presented ignores the rise of China as a major economic force on the world scene. Almost certainly, the Chinese currency will become a major trading vehicle. The same is true for other emerging countries. Some of them will no doubt have important currencies from the point of view of world trade. But will these currencies be traded in the futures markets or in forex?

The changes in just this one area - currency trading - are an example of how things rapidly change and point out the need for traders to adapt. There have of course, been many other changes in recent years. The advent of all-electronic markets has produced markets of a completely different kind. Computers have brought about the ability to trade in various time frames. New exchanges have created new markets and new contracts - so many, in fact, that it is difficult to know exactly where to direct ones trading efforts. It is now possible to trade virtually around the clock. It seems that somewhere, some market is trading.

The Miracle of Forex

My father, who owns a small parts store and garage for vintage British sports cars, called me up recently and droned on and on about how he is getting killed by the Euro. Confused as to how the Euro could possibly be affecting his small and seemingly insignificant business, I asked him how. "Because of the Euro!"

He went on to explain, after calming down of course, that the distributor that he orders his vintage parts from had increased their prices by roughly 30% due to the dollar's poor performance against the Euro. Apparently, it takes about $1.30 USD to buy the same merchandise that may be acquired with 1 Euro.

Essentially, the relationship between the dollar and the Euro is the same as we have always had with the Canadians-only we have become the Canadians in this bizarre scenario!

After getting off the phone with dad I decided to investigate this currency exchange question a lot further and came to one startling but very true realization-the stock market is for chumps! Foreign Exchange is where it's at.

The act of exchanging the legal tender of one country for that of another. People who play the currency exchange market (Forex) do precisely that! With the same amount of analysis or less in most cases, people anticipate the rate at which one currency will convert into another and Presto!-profits please!

So if one anticipates that the Euro will be stronger next week compared with the dollar and I convert $50,000 into Euros, then next week when the Euro does in fact rise I can convert those Euros back into more dollars than I initially invested only a few days earlier-or even the previous day! Why have your money tied up for extended periods of time praying for a good quarterly earnings report or being grateful for the peanuts thrown to you in the form of a dividend?

My father's misfortune illuminated a new world for me. Trading currencies is simply better than playing the stock market and more profitable. Just as with the stocks, you learn which indicators to track and the fundamental principles which propel the market in one direction or the other. There are of course programs and courses out there offered by people who have played this game for years and who are now sitting back in luxury while the rest of us have seen our retirement plans devastated by that volatile mistress known as the stock market. So I ordered a Forex course and learned what I had to in order to start cashing in on this phenomenon. I stopped waiting on earnings reports and praying for those stocks to go up and started making money daily on in the currency exchange market!

My actual startup costs were only $300. Of course I already had my computer and internet connection, but for me the possibility of working only an hour a day from home and earning an extra few hundred dollars a week was amazing.

The course I ordered was Peter Bain's Commercial Currency Trading Secrets. I just liked the idea of having a Successful Trader at my side at all times. And Peter's course allowed me to do that through his DVD's.

This for me is a great way to earn extra income. I might even quit my job one day soon and do this full time. Learn more about this extremely profitable business for yourself. Just go to: http://tinyurl.com/8udgt and check it out for yourself.

Paul Sanford
http://1forex.blogspot.com/