THE MAGIC FORMULA

This was mentioned on the Getting Started page under Advisory Services, but it is so important, I feel it needs its own special page:

If, the day I started trading, someone had sat down with me and said: "here is the *magic* formula. Use this faithfully every time you trade" (and if I had listened to them <g>), then today I would have -- conservatively -- 4 times the account size I do now.

It is that important.

Early on I did hear one trading teacher say "the ONLY 'Holy Grail' of trading is Money Management. But then, the explanation he gave of how to do this sounded very complex to my untrained ears.

Instead this little formula is so simple and it will help you observe the NUMBER ONE rule of successful trading: DON'T LOSE MONEY!!

Here it is:

Rule 1: Take the cash dollar amount of your trading account x 4%. This is the total amount you can spend on any one trade.
Rule 2: Trail a stop for each trade no greater than 25%. Period. (This is a very generous stop!)
Rule 3: If you want to trail a smaller stop on a particular trade, adjust the percentage amount in #1 by the ratio of 25% to % number of your new stop.

Example: you want to trail a 5% stop for a particular trade as you feel if this stock drops (or rises if short) by more than 5%, the trade setup will no longer be valid.
So .. 25% is 5 times greater than 5%. This means you can adjust percentage amount in #1 by 5 times .. i.e. 20%.. you can put 20% or 1/5 of your cash account at risk for this trade. BUT YOU MUST OBSERVE THE 5% STOP!!!

The more mathematically inclined will note that what we are really saying is not to risk more than 1% of your account size on any one trade. Some people use an actual number to do this (and so did I, initially). But using this forumla works better as it makes you compute the proper share size going into the trade. It also makes you calculate your stop loss percentage for each trade, which is what you should be doing in any case.

Examples:

If you have a 25,000 account, 4% = $1000. If you want to enter a trade for a stock trading at $43.25 you divide 1000/43.25 = 23 shares of that stock (round to 20 if you prefer). You only buy 20 shares of that stock & trail a 25% stop. If you are stopped out, you do not lose a significant amount of your trading capital & the winners will more than make up for it.

You can set up an excel spreadsheet that will automatically calculate the correct number of stocks to trade when you input their dollar cost. The forumla is: number/cell where number is your account size x 4%, i.e. 25000 x 4% = 1000; and cell is the cell row & number where you put in the price of the stock. So a stock that costs $25 is put into cell F4. In Cell F5 you can put the forumla 1000/F4 and it will calculate how many shares of that stock you can safely trade with a 25% stop.

What about margin?

I use the above formula for the cash part of my account, for swing & longer term trades. With the margin portion, I use the same formula but using the tighter stop loss for intraday or very short term swing trades. i.e. if I think RIMM is going to make a major intraday move again, I quickly calculate my max % stop loss, which is usually no more than 2-3%, then adjust trade size so using $25k margin, I can buy 140 shares of RIMM @ $70.00. My risk is $1.75 x 140 shares = $245 or <1 % of cash acct size. The potential gain for RIMM on a one day move is usually $2-3 or more. (its ATR or average true range is 1.77 - 2.20) so this is a volatile stock & when it moves, it moves... My risk to reward is about 1:1.10 with RIMM & this is acceptable so I can take this trade. (RIMM is one of my personal favorite plays).
Once the trade is moving in your direction, another smart move IMO is to take 1/2 off when it reaches your first target exit. Let the rest ride, setting a firm stop at your first exit and adjusting (trailing) as stock continues to move.

NOTE: with a 25k account, you actually have access to 75k margin. I would strongly advise a new trader "pretend" this extra is not there .. just use the 2:1 margin or no greater margin than the actual size of your account until you are making money consistently & are very confident!

What about a really small account?

If your account is well below 25k .. i.e. 10 or 15k, then using the above formula you may only be buying 5 to 10 shares of any one stock! How do you make money that way?
Slowly.
But, more importantly you will make money, not lose it. It takes forever (or so it seems...) to turn a little account into 25k, then to turn the 25k into 50... but after that, it gets better fast & if you have developed the discipline in the early days, the experience will come, the account will grow .. and then . it will grow exponentially!