What is money management in stock positions?
Money-, or ‘position’ management, is the part of speculation which is concerned with maximizing the profits you can make in a stock once you’re in it, while minimizing your ongoing risk of being in the stock. Doing it correctly can be the difference between making $2,000 in a trade, or more than $150,000 – while taking the same risk.
Buying, believe it or not, is often the easy part about being in a stock. Entering a stock is a single decision you make. Provided you do not get stopped out and the stock starts performing as expected, following its trend, you enter a different world – a world, in which every day continued holding is an actively renewed decision – a decision that could be right (continued profitability) or wrong (giving back profits, or even falling back into losses).
The first thing you have to learn is that being in a stock is not an on/off question, a black or white affair. Once you’re in a stock, it is more like a list of options (not the derivatives!) gradually opens up to you, options that can possibly expose your capital more and more to stocks that make you good money (i.e. a profitable opportunity) and less to those that make mediocre or no returns.
Holding a stock is thus not unlike a game of chess – awaiting each move the market plays, until it’s your turn again to make a decision and take your own next step.
This guide will be merely an overview of the things you can do with stocks once you’re in them. There are a couple of concepts I will mention here, but they will only tie into a complete picture once you have gone through the premium course and learned the process and purpose of each in depth.
Not mentioned here are position sizing, number of stocks owned simultaneously, and regulation of open risk and exposure in accordance to the market environment. Although critical to understand, these concepts will be taught at a later point once we have covered some other basic materials first.
Money comes to those who can ‘Sit’
Taking your time to await low-risk entry point in interesting stocks will lead you to not buy stocks day in and out. And once you have found one, you should definitely not sell them fairly soon after – unless it hits your stop-loss, of course.
As we established earlier, the big money is made in the multi-month (or even -year) trends. Due to the mathematics behind growing numbers (i.e. price levels), the longer you hold a position, the more the smaller relative %-price progress in a stock produces higher absolute $-returns.
For example, imagine two scenarios, where in Scenario One you buy a stock at $50, hold it to $100 dollars, and in Scenario Two buy it at $100 for the first time. Should the stock proceed to $120, the price difference of $100 to $120 is $20, i.e. a 20% increase in the stock. For the stock position in Scenario Two, this is also a 20% increase ($20/$100). But it is a 40% increase of the position for Scenario One ($20/$50 = 0.4). That is double the return from the same price change in the stock!
Why? If you allocated the same amount of money to Scenario One and Two, let’s say $5000, you would have bought #100 shares in Scenario One and #50 in Two. That means Scenario One would receive a $2000 payout from the $20 price increase (#100 * $20), i.e. 40%, while Two would receive only a $1000 payout (#50 * $20), i.e. 20%. The longer you manage to hold shares, provided the trend stays healthy and intact, the more absolute returns you will receive from smaller % increases later in the trend.
If now the trend persists to $200, takes a breather, and then continues to move from $200 to $250, this is a $50 price change. Overall, this is a 25% increase in the absolute stock price ($50/$200 = 25%). For Scenario Two, this would result in a much better 50% increase ($50/$100), but for Scenario One it would result in a 100% increase ($50/$50). Again, double the return for the longer holder (Scenario One), and four times the change in the absolute stock price.
In total, comparing Scenario One and Two, the price change from $50 to $250 is a 400% return, whereas the change from $100 to $250 is only 150%. Effectively, for every $50 price progress in the stock, the buyer Scenario One doubles his money.**
Holding longer leads to geometrically growing returns the further price progresses in the stock. This is why the famous Jesse Livermore stated:
“It never was my thinking that made the big money for me. It always was my sitting. Got that? My sitting tight! I’ve known many men who were right at exactly the right time, and began buying or selling stocks when prices were at the very level which should show the greatest profit. And their experience invariably matched mine – that is, they made no real money out of it. Men who can both be right and sit tight are uncommon.”
Once you’re in a stock and it is out of reach of your initial stop-loss level, you will spend most of your time watching the stock, letting it move in its trend, and only act when new opportunities open up to buy more of it or when there is a significant development in the chart that tells you to take your profits and run. This can be as short as 10% and as much as multiple hundred percent of up-trend, or more.
When you get in a stock at all, it should be so good that you should be reluctant to let it go soon, as you expected institutional interest and buying demand to stay high and drive up prices substantially. You should only ever respond to what the market and the chart tell you (see below) – shun expert opinions, tips, economic reports, finance magazines such as the Wall Street Journal or Barron’s etc., websites, forums or social media like the pest.
**This is not a recommendation to buy cheap or penny stocks. There is a clear rationale why we avoid stocks that are very low-priced which we’ll explore later. The ‘sweet spot’ of stock pricing for supporting the discussed effect is between the $15 to $50 price levels.
Reward/risk considerations
Trying to sit in a trend until it reverses, comes in line with using stop-loss orders. Since we will be wrong multiple times in a row sometimes, but we want to preserve profitability, the profits we make when we’re right need to be large multiples of the small losses that we record when we’re wrong.
Remembering the earlier lessons on loss cutting and the statistics on being wrong, if we assume for a moment that the maximum loss we will take on any trade is 10% and the average pro speculator is wrong approximately half the time, a statistically sound reward/risk ratio would be 3:1 or higher.
That means, an absolute minimum threshold where we would even start thinking about taking a profit would be at least 30% – that means you could be wrong even twice in a row with a single successful, and still make money (-10% -10% +30% = 10%). However, I emphasize here the “at least”. Once a new market trend starts and you latch on to a strong and virile stock, you’d be a fool to take profits at only 30%.
If you trade the elite stock performers, you will see that such a consideration will often take the back seat, as the profits from such a stock when properly handled and sensible exit rules are followed, will make a 10% loss look like an ant next to an elephant.
Force-feeding stocks – Pyramiding
A great way to maximize your returns in a stock is to keep adding more money to the stock over time – that is, both over the trend and at each specific low-risk entry point.
This process is known as pyramiding. Though a more advanced technique that requires very clear ground rules on what should and shouldn’t be done at any given time, it can really make a large difference to your absolute returns.
Pyramiding, in it’s essence, is buying more of a stock that you’re already in, once you have evidence that your analysis was right, i.e. that you are already making money in it. You are letting the stock show you that your initial idea of selecting and buying it was right, by letting it make you money first. This is followed by you buying more shares of a stock at higher price levels, both within a small handful of percentage points above given low-risk entry point, and also more over the course of the trend at renewed formation of additional low-risk entry points, constructive pullbacks, supportive price-volume action, etc.
If you were right and a stock is already making you money, you can have much higher conviction of putting more money to work in it, and have much higher odds of being right as you go on.
The ultimate treasure reveals itself when applying my concept of ‘exhaustive pyramiding‘, which allows one to shift the risk/reward ratio to extremely low levels. This means to take neglectibly and irrelevant small risks to – what traders call – make a massive killing. To take life-changing account-doubling money or more out of a trade. I share this concept in the Premium guides.
The devil is in the detail here though – you cannot just add to your position at any point and any amount of shares. There are clear rules that need to be adhered to. A basic one is not to add too late in the trend, and that the amount of shares added should be in relation to the risk of the add-on buy point. As well, this is a more advanced topic to be explained in detail in the Premium guides.
Buying at higher prices might sound counter-intuitive, as there is a common notion at Wall Street that you should only buy more stock if the price is dropping, known as “averaging down”. This is one of the big mistakes of amateurs, as a dropping price indicates that you are wrong and are losing money – you should be less exposed to the stock, not more. We will discuss later why that is so – for the moment, let is suffice to know that one of the greatest speculators in the world, Paul Tudor Jones, has a big sign behind his desk, reading:
“Only Losers Average Losers”.
Simplified visualization of possible add-on points in a stock trend:
The market tells you where to finally take profits
We may pay limited attention to the future growth expectations of the company behind the stock before considering to buy it, but once we’re in, the fundamental aspect is out of the picture and rendered meaningless. Apart from the fact that it won’t change substantially, even if it does, the market would have discounted that change long before. From the moment you buy, pretty much the only thing that matters is the chart.
Remember that
- stocks work in future time,
- you as a small speculator never have the full picture, as you do not have the connections or the resources to get information that can tip you off for something that develops in the company ahead of time, as many of the institutional investors have,
- you don’t need the connections or resources, because you got the chart!
For making money, only the price of the stock matters – the change in price, up and down. Earnings, projections, guidance, sales numbers, CEO speeches, CNBC news, forums, or any other external ‘opinion’ in any shape or form does not change your bottom line as a speculator. The fundamental picture can improve to the moon, and it won’t improve your profits – but if the price drops, right there and then you give them back or outright lose money.
As we discussed, the chart reflects speculators’ psychology and decision-making. Since 75% of daily exchange order activity is of institutional nature, the overwhelming information gained from reading charts and price/volume action suggests to us what institutional investors are doing right now, and how it affects price changes in a stock.
Institutional investors might have the resources to know what a company might be going through and how its fundamental picture might be evolving … and they will act according to that knowledge. If they jump ship, something in the picture is likely expected to change in the future … and if no other institutions are stepping into the picture to support the price of the stock with large buying demand, price will sooner or later collapse.
Also, there might also be no fundamental change at all in a company, and the only reason institutional holders want to exit a stock is because they have reached a price target, want to use media buzz or earnings reports as liquidity moments to exit/sell into, or believe the market is “boiling over” from exuberance.
However, the good thing is that you don’t need to know any of this – institutions can’t hide their hand. As we discussed at length, they’re so big that their long buying campaigns as a group literally make or break trends, trends that are monitored in the chart. When they as a group dump a stock for whatever reason, and there is no one left to hold it up with more buying, there will be observable signs of that happening in the chart.
All together, that means that the chart is a prism that you look through to see what institutional money is doing and whether the trend is most likely to stay intact. As long as it does, you stay with it. The moment the chart collapses, you need to get out. It’s that simple.
Put another way, buying is technical and fundamental, but selling is exclusively a technical/chart consideration.
Thus, later in the course, you will learn all the intricacies of chart reading that alert you to positive or negative activities in the chart caused by institutional money. You will learn where to buy more of a stock, but also where to trim off some, or to outright sell your position and take your profits and run.
As for entering a stock, exiting does not have to be a black and white affair – often you trim some off, only to add it on later again – or you take your profits in thirds of the position, to spread risk while still partaking further stock price progress.
Again, this guide more of an overview to the topic of stock position money management than a detailed instruction, in order for you to see how the puzzle starts fitting together. In the final two guides of the free introduction to the course, we will look how the general market and our own psychology tie in, before we venture into the nitty-gritty in the premium guides.