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Money Management Wednesday, June 28, 2006 2:41 PM GMT
by Joe Ross
Money Management
There are some common mistakes I’ve seentraders make in the area of money management. First, let’s understandwhat money management is all about.

Money management overlaps with risk, trade, business, and personalmanagement, yet it has many aspects that make it unique, distinctlydifferent from all of the other areas of management. In this chapter wewant to examine some areas of money management that seem to involvemental quirks leading to costly mistakes.

LISTENING TO OPINION
Kim has entered a short position in crude oil after carefullystudying as many factors as she could reasonably include while makingher decision to trade. She has entered the trade because her study ofthe underlying fundamentals has her convinced that crude oil pricesmust soon begin to fall. Then Kim turns on her television set andbegins to watch one of the financial news stations. An “expert” incrude oil is being interviewed. He begins to talk about how crude oilinventories are almost certain to drop this year because oil companiesare not doing as much exploration as they have in previous years. Kimlistens intently to what he has to say and then begins to doubt herdecision about the trade she has entered. The more she thinks about it,the more panicky she becomes. She considers abandoning her positioneven though she will end up with a loss. The fact that an “expert” hasdecided something else completely shakes her confidence. She exits thetrade intraday and takes a $400 loss. Prices have not come near herprotective stop, which was $700 away from her entry. The market nevermoves sufficiently far to have taken out her stop. By the end of theday, her crude oil futures have made a new high, and in the followingdays 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 inherself.

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. Unlessyou are one of a very rare breed whose opinions are sufficiently goodfor trading, do not trade on them.

Make an evaluation based on the facts you have and then go with thetrade. Just be sure you have a strategy for extricating yourself beforelosses become big. Had Kim stayed with her original strategy and stopplacement, she would have ended up a happy winner instead of aregretful 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 haveclearly defined trading objectives. Trading only to “make money” is notsufficient.

Pete has sold short T-Bonds and is now ahead by a full point. Henotes that he is making money on his trade. Feeling very confident andthinking it would be smart to be diversified, he enters a long positionin silver futures, and also sells short Call options of wheat which heis sure is headed down. Almost as soon he is in the market, wheatprices explode upward and his Calls are in trouble. Pete buys back thelosing short Calls and sells additional Calls on a two-for-one basis ata higher strike price. At the end of the day he looks at otherpositions. Silver had an intraday reversal leaving a spiked bottom asthey 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 endof the day, he finds that most of the money he had made on his shortT-Bonds was used to buy back the short wheat Call options. He coveredthose and now has additional premium in his account, but he also hasadditional risk, and is short Calls in a rising market – not anenviable position. Moreover, he is now worried about his long silverfutures based on the fact that silver closed at its lows on what seemsto be a genuine reversal. To further aggravate the situation, he haslost confidence in himself. What was once a happy, simple, winningsilver long, has now become an ugly, confusing mess, and Pete has agood chance of ending up a loser on all three trades. If Pete keepsover-trading in this fashion, he could end up like the poor fellow inthe picture.

What should be done?
Break every trade into definitive goals. Make sure you achievethose goals before adding other positions. Even with a single shortsale 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 satisfactorilyretire that trade as a winner. Then he could have made his tradingdecision for an additional position. There are very few traders who cansuccessfully manage multiple positions in a variety of markets.

OVERCONFIDENCE
Overconfidence is a particular kind of trap that springs shut whenpeople have or think they have special information or personalexperience, no matter how limited. That's why small traders get hurttrading on no more information than “hot-tips.”

Tim is a farmer. He raises hogs and purchases huge amounts of feedto provide for his hogs. Tim has a large farming operation which isquite profitable. He takes 250 hogs a week to market. Because of asteady flow of hogs from his operation to the market, Tim has no needto hedge his hog business because he is able to dollar average theprices he gets for them. But Tim does want to indirectly reduce thecost of the feed he has to buy, so he purchases soy meal futures. Timlistens to weather and farm reports all day long. He attends meetingsof other farmers, and tries to gather all the information he can thatmight help him be more profitable. But Tim has a major problem, calledtunnel vision. When he looks out at the grain fields in the area wherehe lives, whatever he sees there he extrapolates to the whole world.

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

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

What should be done?
We all need to broaden our horizons. We need a humble attituderelative to the markets. We can never afford to wallow inoverconfidence in what we perceive as special knowledge. A trader cannever afford to let his guard down. Tim thought he knew something thatothers hadn’t yet caught onto. In so doing, Tim made another mistake aswell. 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 existsamong traders. Once they develop a preference for a trade, they oftendistort additional information to support their view. This is why anotherwise conscientious trader may choose to ignore what the market isreally doing. We've seen traders convince themselves that a market wasgoing up when, in fact, it was in an established downtrend. We’ve seentraders poll their friends and brokers until they obtained an opinionthat agreed with their own, and then enter a trade based upon thatopinion.

A student of ours, Fran and her husband, John, decided they wantedto go to live in the Missouri Ozarks. Everyone told them that there wasno 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 themthat they were to serve there. Out of twenty or thirty people theyasked, 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 mostof their possessions accumulated over a lifetime. They moved to theOzarks and went broke within a year. They had to leave and begin allover again. John, who had been semi-retired, now had to find a job. Sodid Fran. She had to give up a promising start as a trader to go out toput food on the table.

What should be done?
Look at each trade objectively. Do not allow yourself to becomemarried to your opinion. Learn to recognize the difference between whatyou see, what you feel, and what you think. Then, throw out what youthink. 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 yourbroker, your friends, or your relatives for an opinion. Turn off yourTV or radio, you don't need to see or hear what they have to say. Takeall indicators off your chart and just look at the price bars. If youstill see a trade there, then go for it.

FEARING LOSSES
There is a huge difference between being risk averse and fearinglosses. You must hate to lose. In fact, you can program your brain tofind ways to not lose. But not losing is a logical thought-out process,rather than an emotion-based reaction.

Two human-based tendencies come into play. The first is the sunk-cost fallacy and the second is the exaggerated-loss syndrome.

Sunk-cost fallacy: You are in a trade that begins to goagainst you. You reason that you have already spent a commission, soyou have costs to make up for. Moreover, you have spent time and effortresearching and planning this trade. You reckon that time and effort ascost. You have waited for just such an opportunity and you are afraidthat now that it has come you will have to miss this trade. The timespent waiting for opportunity is something you also count as cost. Youdon't want to waste all these costs, so you decide to give the trade alittle more room. By the time you realize what you’ve done, the pain isalmost overwhelming. Finally, you have to take your loss which is nowmuch larger than it might have been. The size of the loss adds to yourfear of ever losing again. The end result is brain lock and inabilityto pull the trigger on a trade.

Exaggerated-loss syndrome: You give the importance of losingon a trade two to three times the weight of winning on a trade. In yourmind, losses have greater significance than wins. In reality, neitheris more or less important than the other. In fact, wins do not have tobe as numerous as losses as long as the wins are significantly largerin size than the losses. Of course, best is to have more wins thanlosses with the wins greater in size than the losses.

What should be done?
Evaluate your trades solely on their potential for future loss orgain. Ask yourself, “what do I stand to gain from this trade, and whatdo I stand to lose from this trade?” Think the matter through. “What isthe worst thing that can happen to me if I take this trade, and do Ihave a plan and a strategy for extricating myself long before ithappens?” “If I begin to lose, is there a way I can turn things aroundand come out a winner?” Learn to look at the costs of a trade as partof your business overhead. Try to have a mind set that you will notthrow good money after bad. When you give a trade more room, you aredoing just that – often throwing away money.

VALUING INVESTED MONEY MORE THAN WON MONEY
Traders have a tendency to be more careless with money they’ve wonthan with money they’ve invested. Just because you won money on goodtrades doesn’t mean you should gamble with that money. People are morewilling to take chances with money they perceive as winnings as thoughit were found money. They forget that money is money. Valuing moneydepending on where it comes from can lead to unfortunate consequencesfor a trader. The tendency to take greater risk with money made fromtrades than with money invested as capital makes no sense. Yet traderswill take risks with money won in the markets that they would neverdream about with money from their savings account.

What should be done?
Wait awhile before placing at risk money won on trades. Keep yourtrading account at a constant level. Strip your winnings from youraccount and put them in a safe conservative place. The longer you holdon to money, the more likely you are to consider it your own.

FORGETTING ABOUT MARGIN INFLATION
Before the crash of 1987, S&P 500 stock index futures carriedan exchange minimum margin of about $12,000 . Immediately after thecrash, margins required by some brokers rose to $36,000 and higher.

A trader we know, called Willie, figured that if prices on an indexhe was short went down, he would continually add to his positionwhenever prices first pulled back and then broke out to new lows. Theindex he was trading became very volatile, and his broker raisedmargins to by 1/3rd. Willie was trading a small account, and when hetried to sell short additional contracts onto his already shortposition, his broker would not allow him to do so. Willie complainedbitterly, but the broker was adamant in his refusal. The broker wouldnot allow Willie to use unrealized paper profits to cover theadditional margin required for adding on. He explained to Willie thatto do so would in effect allow Willie to build a pyramid position andthat was not going to be allowed by the broker's firm.

The mistake Willie was making was what some call the “moneyillusion.” Willie assumed that because his position was moving in hisfavor that he had more selling power and more margin. His brokerquickly brought Willie face to face with reality. While some brokersmay allow it, unrealized paper profits do not truly constituteadditional funds that may be used for margin. Willie’s dream offabulous profits from this trade were just that, a dream. Willie shouldbe thankful that his broker did not allow him to get in trouble.Pyramiding with unearned paper profits is not the way to succeed as afutures trader.

What should be done?
You should realize that each so-called “add-on” to an open positionis really a whole new position. Each add-on carries all new risk, andeach add-on brings you closer to the add-on trade which will fail andbecome a loser. When planning a trade, be aware that if the marketbecomes volatile, margin requirements may go up, thereby defeating anystrategy for adding on to your position. There is nothing wrong withbuilding a position one leg at time as prices ascend or descend, butwhen volatility dictates an increase in margin requirements, beware oftrying to add on and be aware that you may not be able to add on.

Option sellers can quickly get into similarly difficult positions.As they roll out to new strikes to defend a threatened short optionsposition, they can find themselves not only facing the need for alarger position, but also facing increased margins in creating thatlarger position. They may discover that they no longer have sufficientmargin to defend a particular position and thus have to eat a sizableloss.

MORE KEY MISTAKES
Throughout our courses we mention some key mistakes commonly made by traders. Here are a few more:

Error: Confusing trading with investing. Many tradersjustify taking trades because they think they have to keep their moneyworking. While this may be true of money with which you invest, it isnot at all true concerning money with which you speculate. Unless youown the underlying commodity, for instance, selling short isspeculation, and speculation is not investment. Although it ispossible, you generally do not invest in futures. A trader does nothave to be concerned with making his money work for him. A trader’sconcern is making a wise and timely speculation, keeping his lossessmall by being quick to get out, and maximizing profits by not stayingin too long, i.e., to a point where he is giving back more than a smallpercent of what he has already gained.

Error: Copying other people’s trading strategies. A floortrader I know tells about the time he tried to copy the actions of oneof the bigger, more experienced floor traders. While the floor traderwon, my friend lost. Trading copycats rarely come out ahead. You mayhave a different set of goals than the person you are copying. You maynot be able to mentally or emotionally tolerate the losses his strategywill encounter. You may not have the depth of trading capital theperson you are copying has. This is why following a futures trading(not investing) advisory while at the same time not using your own goodjudgment seldom works in the long run. Some of the best traders havehad advisories, but their subscribers usually fail. Trading futures isso personalized that it is almost impossible for two people to tradethe same way.

Error: Ignoring the downside of a trade. Most traders,when entering a trade, look only at the money they think they will makeby taking the trade. They rarely consider that the trade may go againstthem and that they could lose. The reality is that whenever someonebuys a futures contract, someone else is selling that same futurescontract. The buyer is convinced that the market will go up. The selleris convinced that the market has finished going up. If you look at yourtrades that way, you will become a more conservative and realistictrader.

Error: Expecting each trade to be the one that will make you rich. When we tell people that trading is speculative, they argue that theymust trade because the next trade they take may be the one that willmake them a ton of money. What people forget is that to be a winner,you can't wait for the big trade that comes along every now and then tomake you rich. Even when it does come along, there is no guarantee thatyou will be in that particular trade. You will earn more and be able tokeep more if you trade with objectives and are satisfied with regularsmall to medium size wins. A trader makes his money by getting hisshare of the day-to-day price action of the markets. That doesn't meanyou have to trade every day. It means that when you do trade, be quickto get out if the trade doesn’t go your way within a period of timethat you set beforehand. If the trade does go your way, protect it witha stop and hang on for the ride.

Error: Having profit expectations that are too high. Thegreatest disappointments come when expectations are unrealisticallyhigh. Many traders get into trouble by anticipating greater thanreasonable profits from their trading. They will often get into a tradeand, when it goes their way and they are winning, they will mentallystart spending their winnings, and may even borrow against theiranticipated winnings to take on additional risk. Reality is that youseldom make all of the money available in a trade. I cannot count thetimes that I had for the taking hundreds or thousands of dollars inunrealized paper profits only to see most of those profits melt awaybefore I was able to or had the good sense to get out. One trader Iknow had $700 per contract profits in a short eurodollar trade. Thenext day his position literally imploded on news of a 50 basis pointcut in interest rates. He was lucky to get out with $350 per contract.The money from trading often doesn’t come in as fast or as plentifullyas you have expected or been led to believe, but the overhead costs oftrading arrive right on schedule. False profit expectations have causedaspiring traders to leave their job before they were really successful.The same false hope causes them to lose the money of friends andfamily. False hope causes them to borrow against their home and otherfixed assets. Too high expectations are dangerous to the well-being ofevery trader and those around him.

Error: Not reviewing your financial goals. Before you make a position trading decision, or before you begin a day of day trading, review your motives and your goals.

• Why are you trading today?
• Why are you taking this trade?
• How will it move your closer to your goals and objectives?

Error: Taking a trade because it seems like the right thing to do now. Someof the saddest calls we get come from traders who do not know how tomanage a trade. By the time they call, they are deep in trouble. Theyhave entered a trade because, in their opinion or someone else’sopinion, it was the right thing to do. They thought that following thedictates of opinion was shrewd. They haven’t planned the trade, andworse, they haven’t planned their actions in the event the trade wentagainst them. Just because a market is hot and making a major move isno reason for you to enter a trade. Sometimes, when you don’t fullyunderstand what is happening, the wisest choice is to do nothing atall. There will always be another trading opportunity. You do NOT haveto trade.

Error: Taking too much risk. With all the warnings aboutrisk contained in the forms with which you open your account, and withall the required warnings in books, magazines, and many other forms ofliterature you receive as a trader, why is it so hard to believe thattrading carries with it a tremendous amount of risk? It’s as though youknow on an intellectual basis that trading futures is risky, but youdon’t really take it to heart and live it until you find yourselfcaught up in the sheer terror of a major losing trade. Greed drivestraders to accept too much risk. They get into too many trades. Theyput their stop too far away. They trade with too little capital. We’renot advising you to avoid trading futures. What we’re saying is thatyou should embark on a sound, disciplined trading plan based onknowledge of the futures markets in which you trade, coupled with goodcommon sense.
Published on Sun, 19 Nov 2006 12:03:10 GMT
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