Management

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Use Effective

like growth stocks or investment real estate. The rest is spread out be- tween things like start-up business ventures or cutting-edge opportunities like bio-tech or alternative energy stocks. Basically, as far as I can tell, they are content to preserve their capital and hope for the best. They don’t want a lot of risk.

All of these various “secure” or “less risky” investments boil down to someone else in control. If I buy a stock investment, for example, the po- tential growth to my capital investment is actually going to be determined by how effective the management team of that particular company is. If it turns out that the management team is unresponsive to the underlying business climate, the potential for that company to continue growing mar- ket share (and stock value) diminishes. If I invest in some kind of bond, the interest rate depends on how long I leave that capital in someone else’s hands. If a city government wants to build a new highway and raises the cash from a bond sale, that city will make more money over time than it will pay me in interest, and it may require me to keep the bond for decades.

All of this is well understood by professional money managers, and those individuals have mountains of data designed to maximize yield and minimize risk. They have huge amounts of capital allocated across as many different market opportunities as possible and they pay the yield to you, the investor (less any fees). As the investor, you must be content to receive whatever gain that particular money manager’s skill set is capable of earning. The professional money manager is not a risk taker. He is a risk avoider.

For us as traders the game is completely different. We are looking to exploit some perceived opportunity when we see the current market price as too high or too low relative to some other price we are expecting to see trade down the road. We start from the premise that the risk is certainly worth taking. But knowing the perfect price/time relationship to assume that risk is the difficult part. In my view, we have this problem because we don’t know that asset allocation and money management are for invest- ments, not trading. Trading is about getting paid for a risk someone else doesn’t want to take.

If you study wealthy individuals who started with nothing, you will discover there is a common thread behind all of them. They all take con- trol of their finances and allocate resources differently than the average person. They assume risk others will not—and the lion’s share of profits goes to them. Most of the self-made wealthy people have discovered that people will pay to avoid risk. This is also where the concept of other peo- ple’s moneycomes into play. Without question, the proper use of your cap- ital will lead to using someone else’s capital, thereby creating leverage for the risk taker. In the markets we call that margin. If you are trading crude

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oil, for example, the total contract value is much larger than the cash de- posit needed to control that contract. That crude oil is somewhere in the world for the time you control it. Someone is willing to let the price change either for or against him, and one of those someones is a hedger.

Knowing when hedgers are active in the market leads to knowing how to properly allocate capital.

A hedger’s goal is to transfer risk to the speculator. Youare the specu- lator. When the hedger feels it is time to transfer risk to you, it is time to allocate your capital and take the risk. Properly use of your capital begins with accepting risk. Individual traders who hope to profit without assum- ing a lot of risk are setting themselves up for a trading disaster. Trading the markets cannot be done successfully unless you assume risk. When someone who does not want the risk is active, you have a time/price rela- tionship that has a very good chance of being a place to assume risk. The key is understanding that low rates of return are paid to non–risk takers, and high rates of return are paid to risk takers.

Using our crude oil example, when a hedger sellsinto the market, that particular hedger sellscrude oil because he believes a price decline is pos- sible, even likely. By using the markets to hedge he is saying, “I don’t want to risk a price decline.” Who would be most likely to know if a price de- cline was possible? Wouldn’t that be someone in the business of selling crude oil for a living? The moment the hedger becomes active, you have a very good clue that it is time to allocate capital and assume the risk that the hedger does not want. You now take your capital and leverage his knowledge.

Now, I am not saying that you should sell into the crude oil market just because the hedgers are selling crude oil today. I am saying that prop- erly allocating your capital begins by knowing who does not want the risk in the market, and accepting that risk. In most cases, simply knowing the price levels at which the hedgers say, “That’s enough” gives you the best place to begin using your capital. Effective money management begins with assuming the right risk at the right time. The rest is academic.

Why is this point of view the cornerstone to effective money manage- ment? Because the markets are designed for the hedger and not the spec- ulator. The speculator is attempting to profit from a perception of price potential. The hedger is using actualprices. In most cases the hedger is looking for a change in price when he participates. If the price change does not occur he is not harmed. If the price change does occur, he is pro- tected and he provided you the opportunity to benefit from that change. In most cases, hedging activity will stop a price advance or decline, or at least delay it. Knowing when and where hedgers are active provides im- portant clues for when it is time for you to take the actual riskand the benefit your account.

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The perceptionof risk is what most money management concerns it- self with and this perception of risk is what most traders focus on. They want to play but they don’t want to pay. There is only one risk in the market: that you may be on the wrong side of the net order flow. You can perceive that situation immediately by the very next traded price, so per- ception of risk is not really a concern—except for the trader who is igno- rant of or unwilling to accept the actual net order flow. What you want to avoid is executing for your initial position in a place that is of no interest to the person who ultimately receives the best benefit from the markets.

You do not want to buy and sell from other speculators. You want to ei- ther buy or sell with the hedger or against the hedger; but you want to avoid participating against other speculators for the most part.

Once you are accepting the risk others do not want, and the market is moving favorably for your initial position, the rest of proper money man- agement comes into play, but this is only valuable because you still have your original money to begin with. If you have been trading for a reason- able amount of time and a reasonable number of trades but your equity is lower than your starting balance, the only thing you need to discover is how to get on the right side of the net order flow more often. One valuable clue is knowing when hedgers are active, because they will execute to avoid risk only at price areas that are actually important. The fact that most speculators are losers means that a certain amount of them will be available for the hedger to square off with. Who is more likely to win, John Q. Public or Cargill, when both are trading in the wheat market?

Once you have a winning position working, you must allocate more resources to the winner. The four basic rules for money management at that point are as follows:

1. Roll protective stops to the break-even point.

2. Purchase options to lock profits.

3. Add to the winner on pullbacks.

4. Scale out when hedgers from the other side become active.

I have found that a 1.5% equity risk on initiation of the position will keep you in the game until you have found the winner and have a lead on the trade. Using options to lock profits will free up equity to add to the winner. When hedgers from the other side are active, the limits to the playing field are established and liquidating some or all of the position is advisable.

Now, I know most traders were expecting this rule to be a discussion of ratios, percents, stop placement, and so on. In the Introduction I pointed out that making the rules work depends on understanding the

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psychology behind the rules and adapting that psychology to your per- sonal trading approach. The psychology behind using effective money management is first and foremost preserving your capital until you find the winning trade. That’s easy enough; don’t risk more than about 1.5% of your starting balance on any one trade. Once you have a lead on the win- ner, you add to it and let it work. You liquidate when the net order flow dries up in that direction. You are looking to initiate when the net order flow is set to change, and you are looking to liquidate when it changes again. In between those two points you are looking to add to your winner and lower your open-trade risk, either by rolling stops or buying options against your futures.

The best way to effectively manage your equity is to look for the risk no one else wants to begin with. That is usually a price level that is of in- terest to hedgers. The rest is common sense.

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