Money and Portfolio Management with the PCCRC. PART II

For traders, money management is as important an issue as the selection of candidates. In fact, some experienced traders go as far as to say that the may have as much as 60% losers, and still make money, thanks to their money management strategies. Stock day traders may be out of a trade before the day is out because precisely because they fear holding stocks overnight. Swing traders may place a stop loss order right with the entry order to avoid an intolerable loss in any individual trade. A 10% loss in a $10,000 position in a $100,000 represents a loss of 1% of your account, which should be easy to absorb. So lets start with the premise that we will place a stop loss at 10%.

One of the most important features of options trading is risk management. If it is true that you could lose all of your capital in most options trades, it is also true that you can limit the cash overlay. If your risk tolerance is 1%, then you can just as easily place a bullish vertical spread with a $1,000 maximum risk. You don’t even need to place a stop loss because you have already stipulated ahead of time that a 1% risk in your $100,000 account is easily absorbed. However, at a $1,000 risk per trade, it may take a lot of effort for you to put all of the $100,000 to use. Ultimately, if we are to get rich, we are not going to make it with 10 x $1000 trades. However, 1% may be an adequate starting point, and you may increase it to 2% or 3% or even 5%, as some would advocate. Placing a stop loss with options makes little sense because options have a defined risk, and the goal of a stop loss is to define the risk!

The second aspect of money management is the exit strategy. Some place trailing stops. Under the conditions of a trailing stop, the stop order price of your stock would rise with the stock price but not go down with any pull back. Again, if the stock goes down 30% overnight, the stop loss will simply be triggered but filled at the market price, leaving you with a 30% loss. You can also use you knowledge of stock technical analysis to make the decision to exit a trade. I like using candlestick reversal patterns in combination with Bollinger Bands to exit my positions. However, this requires that you monitor the chart of your trades at least once a day, if you want to make the most of every trade.

When trading options, trailing stops may not be that useful. After all, the price of an option may be more volatile than the price of a stock, and you may be triggered out prematurely. If you trade spreads, then such orders are not very useful either. I have been experimenting for several months now with call debit vertical spreads + 1 call. For example, I might buy 11 calls and sell 10 calls. Once my target is reached, I can exit the either the spread, leaving the call for a surprise move up. If the stock does not follow through, at least I have a profit. Because I use Elliott wave analysis to trade vertically, and because my risk is defined, I don’t mind leaving the trade to do its thing, without me monitoring it daily. I am prepared to lose all of the capital in the trade, since it does not exceed 2% (this is my preference) of my account.

By far, the most elegant approach to money management and portfolio management is obtained with the PCCRC. This will be the subject of the next installment of this series.