Friday, 30 January 2009 Issue #480

*** Don't end up in the Traders' Graveyard...!
*** The 5 cardinal principles of trading...
*** Have you got the qualities of a day trader…? and more...

From Julie Brownlee

Dear Investment Academy reader,

Money management – reducing your risk by setting limits

Trading is very serious business! If you don’t have all the right elements in place before you begin trading, you’re dead. This may sound like rhetoric, but I can assure you, it’s actually the essence of trading. Trading isn’t black and white, it relies much more on your own mindset to work.

The markets are based upon supply, demand and psychology. To protect you in such varying and unknown conditions, an essential element of your methodology is a strict money management system. You must know where you’re getting out before you get in, what the maximum loss you’ll sustain is and what effect this may have on your amount of trading capital.

Making a loss on a trade is nothing much to fret about in itself… it’s a part of the business. But losing too much of your trading fund on losing trades is a slippery slope towards the Traders’ Graveyard.

Your trading fund requires discipline

It stands to reason that if, for example, you have R10,000 available to trade with and you’ve spotted what you believe is a wonderful trading opportunity, don’t risk it all on that one trade! If you risk the whole lot on one trade and it goes wrong, not only have you got no more money left to trade with, but you may also be in debt to your broker.

A disciplined trader doesn’t get ‘gold fever’ from the prospect of making a huge profit in one super strike. Instead, he or she ensures that the smallest practicable proportion of their fund is risked on any one trade at any one time.

It’s impossible to arbitrarily say how much that should be but, as a guideline, many professionals tend to operate with a 2% risk (to a maximum of 10%).

So say you spot share XYZ at 400 cents. You have R10,000 in your fund and decide to risk 10% of it on the trade. This would be R1,000. R1,000 divided by R4 is 250 – so you buy 250 shares.

TRADER TIP: Remember, although the theoretical upside to a share price is limitless, the downside potential is always to a value of zero.

Stick to your plan, control your risk

Money management principles and commonsense trading are just as important for day traders as they are for large position traders. In addition to managing your trading fund, it’s also important to exercise control over the actual money riding on the trades themselves.

NEVER trade without a game plan. Paying money for a computerised trading system and a live quote feed, and waiting all day for the system to issue a signal, isn’t a game plan… it’s an insane way to trade. If that’s what you’re doing, rather give your money to a professional to trade for you.

There are five cardinal principles that should be part of every trading strategy. They are:

** Trade with the trend
** Cut losses short and treat them as a normal part of a trading business
** Let profits run
** Don’t average trades, or add to losers
** Don’t overtrade

If you want to be a successful trader, your best chance is with a trend following system that can work just as well on short-term price movements as it does with long-term ones. It stands to reason: The downside of day trading is the more you trade the more you can lose. So it makes sense to learn how to identify a trend and only trade with it. This means you should always trade in the direction of recent price movement, not against it (called ‘bucking the trend’).

In day trading, you can only let your profits run to the end of the day. This means your average trade (the average profit of both your winning and losing trades) must necessarily be much smaller than if you could let your profits run for days, weeks or months. However, your costs of trading, commissions, slippage on the bid offer spread, and mistakes stay roughly the same on a per-trade basis. So, your day trading system must be much more consistent and robust than a longer-term system to stay ahead of the costs of trading. Few day trading approaches meet this test. In short-term trading, as opposed to day trading, you can let your profits run.

TRADER TIP: Just because you’re a day trader doesn’t mean you must trade every day. Wait for good opportunities. Tomorrow’s another day.

It’s also better to make small profits ten times than wait for the one big profit that may never come. Bill Greenspan, a seasoned American day trader, states that one of his cardinal rules is: “Make 10 cents on a million trades – not a million cents on 10 trades.”

TRADER TIP: The first hour of the trading day is when the market tries to establish the beginnings of any trend for the rest of the day. If you can read that correctly, you’re under ‘Starter’s Orders’ and ‘ready for the off ’. The last hour of the trading day can be sheer chaos, so don't open a new trade after 4.30pm. Also try to close all your day trades by 4.50pm.

George Angell, a well-known author, system designer and day trader of the American market, says: “One extreme of the day’s range ahead is often contained in the price action within the first 30 minutes of trading.”

Happy trading!

Julie Brownlee
For the Investment Academy