I’m thinking of giving up my day job and fancy a quieter life spread betting for a living. I traded gold a few years back and wasn’t wholly successful (luckily that was using someone else’s money). The trouble is I’m not very good at looking after money. I started well, but became complacent as the profits poured in and now I’m in a hopeless mess. Could you give me a few tips on managing the risk on my spread betting account?
Our mate Gordon is nearly a fictional character. However, some of the recent comments posted on our web site suggest that it wouldn’t be a bad thing to go over a few of the basic guidelines for risk management. Those of you who are already up-and-running money-machines feel free to add your own tips and experiences.
Firstly Id like to congratulate you on your decision to give up the day job; it doesn’t really suit you does it love?
I haven’t got the column inches to go into your problem in any depth, but here are a few of the key pointers to help you on your way.
Firstly Gordon, you’re in good company. Top traders make their money on between 40-60% of trades (so it doesn’t take your pal Alistair to work out that 40-60% are losing trades). The top traders get rich by making more on the winners than they lose on the duff trades.
The average trader will improve massively over the first couple of years; the tricky bit is not getting through your trading capital as quickly as your tax revenues. So we need a few simple rules (but you can’t keep tinkering with these every time you overspend).
Look After your Money
Firstly, you want to create a buffer zone. Start with small bets to create a new layer of capital (your profits) before increasing the bet size. Gradually increase the bet size as your capital grows but save your shirt for a night out with Sarah, don’t go losing it on a gold bet.
Once you’ve got past that stage, you need to think about preserving your capital. Sure, you’ve gotta risk some capital in order to trade. But protect it like a fine Scottish Malt. Remember, it’s a tough act, but admitting you’re wrong and getting out of a trade will give your trading capital a longer shelf-life.
On the other side of the coin, trades will go wrong (a helluva lot of them according to all the stats). The losses will eat into your capital, which might put you off dealing. And that’s OK for a short while. I have a ‘3 strikes and out’ rule; if I lose on three consecutive trades I take a time out. I know I’m out of touch with the market or I’ve offended the trading gods. Either way I’ll have a Kit-Kat or go to the gym.
But trading’s the game, so after a period of reflection and perhaps a review of your strategy, it’s time to cautiously get back on the bike. It’s no bad thing to drop the bet size to allow your confidence to return with a few less stressful wins before returning to your normal bet size. Another option is to pick lower risk strategies until you’ve started to re-build the capital base.
I Have A Cunning Plan M’Lord
See, Baldrick got it spot on. Taking risk management seriously means planning your trade before the finger hits the button. The Billy Bodgit way is to hit the button then have a think about changing the default stop loss. But just like the Billy Bodgits you see plumbing, mending your car or in Cabinet posts, you soon realise that you’ve just p*ssed your money away.
The trade plan is a discipline, the theory is that if you take the time to work out your stop loss and exit points you’ll avoid the impulse trades. I’ll put my hand up to this one. Mostly I open a bet with a known stop loss and a rough idea of where I’ll start taking profits. But there are times when I’ll hit the button on a bit of news and then worry about the other bits. And occasionally, especially in the forex markets, I’ve come away with some big wins. The main thing is that I’m not kidding myself. The long-term approach to profits is to keep the discipline.
A proper trade plan should show where you’re prepared to enter the trade, where you get out if it goes t*ts up and where you’re aiming to take profits.
Traders target a risk: reward ratio, which varies according to the size of their dangly bits; a popular ratio is 3:1 (the potential gain is 3 X the potential loss). In that way they make money even if only one in three trades wins. This style, which means they’ll turn down a trade with less than a 3:1 ratio sets them apart from the scalpers or snatch and grab merchants (oops, that’s me at times).
Get Your Figures Straight
A lot of newbies start by deciding the bet size then work out where to put a stop loss; risk management suggests the opposite.
The smart move is to limit the possible loss on each trade to a set percentage of your trading capital. Typically the big swingers might look at risking 5% of their capital on a trade, but you can play with this percentage to suit the size of your capital and risk tolerance. This allows you to get a few wrong without denting your confidence or bank balance.
Supposing your trading capital is £5000 and you’re willing to trade 5% of your capital. That means you’re prepared to risk £250 on the trade. You want to sell FTSE at 5400 with a stop loss at 5450 (50 points above). That means that you can afford a bet size of £5 (£5X 50 points = £250). A wider stop loss would lead to a smaller bet size; a tighter stop would allow you to risk a bigger bet.
OK, so that’s a brief guide to planning a trade. Here are just a few ways of not making money:
George Greedy and Fanny Fear
George Greedy wants that Aston Martin and he wants it now. He’s the type who’s always jumping on any moving market, ignoring the warning signs and more likely to double his position at the top rather than scale down. He likes casinos and fast cars, and is likely to make the fast bucks-then lose them along with the shirt off his back.
Fanny Fear is very cautious, rarely trading unless her strategy is backed up by Russell Grant’s star sign predictions. Fanny Fear will remember risk and money management but her cautious nature will lead to taking profits too early. This means she struggles to cover the losses from when her stops are hit.
The really important point that these two characters are trying to make is that there’s no place for emotions in risk management. Investor psychology is a pretty big subject in itself.
This one is quite natural, but likely to bring you back to earth with a thud and a big dent in the trading account. A winning trade is always good, two in a row brings a twinkle to the eye, but three or four winning trades and you’re the mutt’s nuts. Why mess around with £5 bets, let’s haul in the bigun.
Of course that’s when the market turns and you realise just how quickly that red ink spills over on a higher bet size. City banks reward their successful traders with sums that would give us wet dreams, but they also reduce their trading capital after a purple patch. These guys know that the winning run won’t last or that the dealer will get overconfident, so they reduce the risk-it’s a trick worth remembering.
Don’t Go Down With The Ship
Anchoring is one of the deadly trading sins. This is when we focus on a number that should have no part in the decision-making, but which tends to dominate more rational thoughts. Hey, who’s sold a house recently? Keep your hand up if your main aim was to match/beat your original purchase price, regardless of recent price falls. That’s anchoring, holding out for an unreasonable price. A trading example would be not selling below the purchase price, or even refusing to take profits below the previous high.
So in a nutshell Gordon, here’s your easy to remember list of how not to lose your money:
- Look after your trading capital; that’s what keeps you in the game. If the reason for placing the trade disappears, bail out and save your capital for the next bet.
- Start small and increase your bet size as your capital increases.
- Plan your trade and trade your plan. Work out your entry, stop and exit points before you deal.
This advice won’t help you to pick the winners, but it’ll keep you in the game long enough to learn.
Hope that helps, now where’s that letter from ‘Tony who can’t stop grinning’?