Do you know that even though a group of traders buy the same stocks or options at the same time, some of them may become millionaires over time and some of them simply go broke?
All things equal, the most important factor that determines if you would become a millionaire (or billionaire?) or a complete loser over time trading in the stock markets is not how accurately you can pick stocks but how you manage your trades! Yes, portfolio management, or on a more micro scale, trade management, is the only factor that determines whether you make it or not in the stock markets!
Trade Management Example
John and Peter are 2 stock traders who agreed at the same time that XYZ company stock is bullish and decided to buy XYZ stocks together.
XYZ is trading at $10. John and Peter have $1000 each. John decided to put all his money into XYZ stocks and bought 100 shares of XYZ stocks. Peter decided to stick to his trade management strategy of using no more than 30% of his equity into any one trade. Peter then bought 30 shares of XYZ stocks.
As it turned out, stocks that are expected to go up usually come straight down. Instead of going up, XYZ company stocks fell from $10 to $6 within a few days. Both traders decided to sell their positions in order to preserve equity. John is left with $600 while Peter still has $880.
Both traders then bought ABC company stocks trading at $20 with the same trade management strategy. ABC rallied from $20 to $35 and both traders sold their positions. John is now up to $1050 while Peter is now up $1078. Peter remains ahead of John on the same moves while risking only 30% of his equity.
Both traders then bought RAT company stocks trading at $100 with the same trade management strategy and this time, RAT was delisted. Both traders lost all their equity in RAT Company. John is now left with nothing while Peter has $754 left.
The example above is based on the worst case scenario which is familiar to many veteran traders. You would see that Peter’s 30% trade management strategy reliably reduces losses and because he lost less money than John, he needs only make a lesser amount to beat John to it. Over time, Peter will out-perform John. See what I mean?
Trade Management – Conclusion
A sensible trade management strategy may not feel as exciting as throwing all your money in at every trade and it may also result in frustration when a stock does very well but on those much more times when a stock failed to perform, you would always be glad you stuck to your trade management strategy. As Rocky Balboa said, it is not about how hard you hit but how many hits you can take. A sensible trade management strategy ensures that you are able to take many hits and still not go down.