Using Money Management for your Investments

by Palmer Owyoung

Adam Smith said- The problem with paper money is that it rewards the minority of people who can manipulate it and makes fools of those who work and save for it.

You don't need to be a rocket scientist or mathematician to understand the financial markets. As a matter of fact George Soros, the equivalent of a financial rock star has often said that he isn't very good at math.

If you're like most people you're very frightened of the markets and have been told that it's like gambling. Everyone has heard the story about their friend's, cousin's, boyfriend who lost everything in the markets and is now flipping burgers at the local diner. Not to diminish the dangers of the stock markets because for the uneducated these waters can be a perilous place to tread. However driving can also be hazardous, so in order to reduce the risks we take classes, wear our seat belts, pay attention to road conditions, drive at a reasonable speed and rely on improving technology to keep us safe.

The same can be said about the markets. With a bit of education and experience we can keep ourselves from ending up flipping burgers at that diner or crashing and burning.

The first and most important lesson with regards to spread trading or any type of trading for that matter is to understand how much risk you are taking before you enter a trade.

We use the 1-2% rule

That is to say on any one trade we will only risk 1-2% of our total trading account. So if you have $10,000 you may risk $100-$200 on a single trade.

The second rule is that we will never have more than 6% exposure on at any one time. So you may have 3 trades on with a 2% risk or 6 trades with a 1% risk. You may not enter another trade until one of these trades has moved up and your stop loss is at break even or until you've closed out one of the positions. This way our trading account is in 94% cash at all times and we can sleep well at night.

These two rules are simple, but again they are the most important rules in trading.

1.Risk only 1-2% of your total trading account on a single trade.
2.Risk only 5-6% of your total trading account capital at one time.

Knowing these rules will also help you with position sizing and tell you how many contracts to purchase. For example if we purchase an options contract worth $200 we will generally use a 40% stop loss. So if we have a $10,000 account we can purchase up to 2 contracts risking $160 or 1.6%.
Using a Stop Loss
A stop loss is simply an order that you leave with your broker to eliminate your position if the stock or option drops below a certain price. This order will execute whether you are logged into your account or not. In the case of options we usually use a 40% stop loss. So again if you purchased a $200 option you would close the trade off if it dropped $80 or more.

I once read that 75% of retail investors don't know how to use a stop loss. I'm not sure if this statistic is accurate or not, but this gives you an indication of why so many non-professional investors are worried about ending up at the diner.

IF YOU DON'T USE A STOP LOSS THEN YOU ARE GAMBLING!!

About Palmer Owyoung
Palmer Owyoung is the founder of OptionSpreadTrades.com, a website dedicated to helping the small investor achieve financial independence.
Its goal is to educate and to help people learn to manage their own money.

Average returns of 5-15% per month.

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