Capital Commitment
Money management is about how much of your capital you should speculate on a given trade, and when. Here is your safeguard against being wiped out too quickly by oversized trade. Good money management does not guarantee success but you will not get very far without it.
In 1987, US trader Larry Williams turned US~$10,000 into US~$1.1 million within 12 months and he attributed his success to money management. Williams bought more contracts when he had plenty of cash and less when he did not, which sounds simple enough but, like other aspects of money management, it requires self-discipline.

The first rule of money management is to decide how much capital you will commit to trading. If you are on the cautious side, you could start with 10 per cent of your savings. If your savings are £100,000, this would be £10,000. If your savings are much smaller, you could use a higher percentage, although it increases the risk.

To preserve your trading capital is your priority and you should not trade with too much of it at once. If your capital is between £10,000 and £20,000, you must commit up to 5-10 per cent of this to every trade to make the dealing size meaningful. If you have a larger capital base of £100,000 plus, you need commit only 1-2 per cent of this to every individual trade. I have known traders put 25 per cent of their capital on every trade, and once they have taken a few big hits, they are wiped out.

When to Buy
You should have a good reason for buying any stock. If, for example, the company has just jumped a regulatory hurdle, enabling it to launch a favoured new product, it bodes well. The trick is to buy early, perhaps on rumours, before the share price has fully reacted.

As a novice stock market speculator, you should favour larger companies. The shares are the most liquid, and may be traded at the narrowest spread. In recent years, many of these stocks have become volatile, which has created huge profit opportunities for traders.

Small companies are a slightly different trading proposition. They can be fantastic when you get it right because the share price can jump 30 per cent, 50 per cent or more within weeks, days or hours, entirely on sentiment. But wait until you are experienced before you trade such stocks. The shares are comparatively illiquid and, if you buy and the price plunges against you, you may find yourself as good as locked in. For more on small companies.

Buy shares that have relative strength, which implies a strong recent price performance compared with that of others in the sector. This should be over the past month or two, and over the past year. In such cases, the P/E ratio is likely to be high.

You can calculate relative strength as follows. Divide the price of your chosen share by the figure for the Actuaries All-Share index at close of business, and the result is the relative strength ratio. Recalculate this ratio every day over some months, and plot the line on a graph. If the line is moving up, so is the share’s relative strength, and vice versa. Some investment software and online services will do the work for you.

At some popular financial websites such as Interactive Investor (www.iii. co.uk), you will find details of the day’s biggest winners and losers. Early in the morning, it can be profitable to invest in yesterday’s losers, as well as in stocks that have just started rising.

As a rule of thumb, professional traders prefer the upside on any trade to be twice the downside. The worst loss that you allow should be only 2 per cent

HOW TO WIN AS A SHARE TRADER 141 M
of your trading capital, which, based on trading capital of £15,000, would be £300. This way, you will have enough capital to withstand some consecutive losses.

If a stock is doing well, you may want to pyramid your position and buy more. Some traders keep buying a favoured stock in stages, but never in so large a quantity as the last time. Jesse Livermore would buy a small shareholding in a favoured stock to test the market and, if he made money on it, would take more - but only at a higher price.

When to Sell
Jesse Livermore always sold shares if they started making a loss. It is a good example to follow. Most are reluctant to sell out of a losing position because it crystallizes the paper loss. They prefer to hang on in the hope that the share price will rise again.

When you buy a stock, set the percentage rise at which you plan to sell it. The share price needs to rise enough to cover your dealing costs as well as the bid-offer spread and, on share purchases, stamp duty.

You will need significant returns to make trading worthwhile. In a seven-month study, the North American Securities Association found that 70 per cent of day traders lose money.

Cut Losses and Run Profits
In the HSL newsletter (www.hsletter.com), international trader Harry Schultz has said: ‘Do professionals spend hours trying to find the next “hot” stock? No. True professionals understand that preserving original capital and not taking big losses is the secret. Don’t worry about small losses.’

This brings us to a key principle of money management. Cut your losses and run your profits. This can be profitable for you even if you pick more losing than winning stocks because, under Pareto’s Principle, 80 per cent of your profits will derive from 20 per cent of your trading. As speculator George Soros has said, it does not matter how often you are right when you trade, but only how much you lose when you are wrong.

To play safe, get that stop loss in place before you enter your trade and, if the stock declines below your cut-off point, sell automatically. As US trading guru Victor Sperandeo puts it, if an alligator has your leg, sacrifice this because, if you struggle, it will get more of your body. UK trader and seminar leader Mike Boydell has said that not using a stop loss is like running across the M25 with your head in a bucket.

The simplest stop loss is the conventional type where, if the shares should fall a given percentage below the original purchase price, you automatically sell out. I recommend that you instead use a trailing stop loss, which is reset daily against the previous day’s closing price, and so trails the share price.

Your key decision is the point at which you will cut losses or stop running profits. Jesse Livermore would sell stocks when they were still rising but, on his judgement, were about to run out of momentum. For most traders, it is usual to sell a stock after the share price has started declining, and so cut the loss.

Some traders set two trailing stop losses. If the stock hits the lower stop, it serves as a warning, and you may choose to sell half your shares. At the higher stop, you must liquidate your holding.

In setting the cut-off level, consider what US trader Marty Schwartz has called in this context your uncle point. This is the point as in the children’s game when you shout the word uncle, indicating that you give up.

The famous US trader William O’Neill cuts losses at 7–8 per cent below the buy price, but this is very tight and may require you to sell out on temporary dips. I suggest that you set your stop loss percentage at a maximum 15 or 20 per cent. If you are trading shares in small companies, these tend to be volatile, and a stop loss as high as 30 or 40 per cent may be needed to cover fluctuations that are not a proper trend reversal.

Occasionally the shares will have fallen too fast to get out in time, in which case you should exit at the highest price. Sell at once and ask questions afterwards.

Technical analysts have their own version of the stop loss. True to their art, it is based on share price movement as shown in the charts. One approach is to sell shares on the first technical pullback from a new low. This can be hard to detect.

Technical trader and guru Alan Farley has argued on Trade2win (www. trade2win.com) that you should avoid percentage stop losses because they could be wiped out by market noise, and they give an illusion of controlling risk, but not knowledge of the extent of the risk. Farley’s case is that it is most effective to place a stop loss on top of converging resistance shown in the charts.

Do not be fooled by traders who boast that they never use a stop loss. Most will sell out quickly once the stock has started plummeting and so are applying the discipline in all but name. If you find that you are always using your stop losses, switch to buying Put options. I know of traders who have made this switch very profitably.

There are exceptional circumstances when you might choose not to apply your stop loss. In his book Secrets of a Millionaire Trader, Richard Farleigh says that you should not cut losses on an adverse price move if you understand why it happened, remain confident of a recovery and have enough capital not to sell. ‘Here it may make sense to hold the position and even to consider buying more. But I would still like to see the market starting to recover before I added to a position,’ he says.

This module is about trading. Do not confuse the concept with longer-term investing, which has less need for stop losses. Anthony Bolton, fund manager at Fidelity Special Situations Fund, says he does not use stop losses. ‘I like to keep reassessing the story. An automatic stop loss is sometimes right and sometimes wrong. It’s difficult to use on big holdings but it could make sense for individuals.’

The flip side of cutting your losses is to run your profits. This way, you can benefit from any occasion when the stock price soars beyond expectations. If it happens a few times, it will more than compensate for small losses taken in a good many other stocks. You must dare to let your profits mount up.

Unfortunately, some traders have a set idea of what constitutes a normal profit and feel uncomfortable if their position overreaches it. If you are in that camp, scalping may appeal. As a scalper, you aim to snatch plenty of small profits rather than to ride a few large ones. You will trade often in small sums, which means your gains will be limited in size but more frequent. You will need to do a lot of trades, and it is hard work. You may slip in and out of the same stock several times a day.

For some traders, scalping can work a treat, but for others it is like a treadmill that makes no money.

If in Doubt, stay out
If you are having a run of unsuccessful trades, stop. As legendary share trader William Gann wrote in How to Make Profits in Commodities: ‘When you make one to three trades that show losses, whether they be large or small, something is wrong with you and not the market. Your trend may have changed. My rule is to get out and wait. Study the reason for your losses.’
When markets are not doing much, it is another good time to take a break. You will have the opportunity to assess your mistakes and prepare for the next bout of trading.