What constitute a good money management system? Think of a turning car carburetor is to get 2 things right: air flow and fuel mixture. Thus , a sound money management system ensures the flow of money and maximum capital preservation balances against the power of making profits!
In stocks or options trading , your first priority is not to make money , but rather to preserve your capital , for whatever % of money you lose, you have to make a larger % to come back to that same level .Remember that we must always live another day to fight the war . You are not a good trader if we cannot stay in the game long enough.
The next question is that what do we then mean by staying in the game? We ask ourselves the following:
Firstly, it is important to calculate the worst scenario and ask if we can live with that risk
Secondly, if the worst case scenario happens, will it wipe out our capital or severely limit our ability to trade? If the answer is yes, then we should reduce the numbers of shares or option contacts until the risk is livable.
Thirdly, we must be able to define the difference an acceptable risk and an unacceptable one and finally, calculate the probable gain on the trade versus the risk and ask yourself if the trade is worthwhile.
The money management commandment that I stick strictly is I shall not invest more than 5% of my money into any single trade. The beauty of the 5% rule is that it allows me to increase the size of each trade when I am doing well and forces me to cut back when I am doing poorly. Assume you have an investment capital of $10,000 and therefore have 20 games on hand .When the stock has an upward momentum, you want to ride it as long as possible and then take profits and cut loss immediately as soon as you realize you have a downward momentum, In this way, you probability of making big profits on a few good trades are good enough to keep you in overall net profitable position against a few bad trades through proper risk management. Professional traders observe this 5% rule all the time, then why should we not do the same?