Money Management

Two weeks later, my $20,000+ account had plummeted to lessthan $2,500! Now, I was devastated. My pride had been crushed andI was right back among the 90 percent of people who lose money trading.What happened? That was my question. I decided to take sometime off from trading and investigate exactly what had happened to1012 WHY (PROPER) MONEY MANAGEMENT? WHY (PROPER) MONEY MANAGEMENT? 13this account. I was going to figure out what had caused the collapse ifit was the last thing I did. Defeat is only temporary.After analyzing the trades, I determined that the most reasonableexplanation for the demise was overtrading the account. However,this was new territory to me. My first account was a $2,500account where I bought five bond options (or five of one market, I amnot sure whether it was bonds or crude oil). I put the whole amount,into that market. Two weeks into the trade, I had doubled my money.The day the market went my way, causing the prices of the options tospike, I called my broker to get out. However, he convinced me thatthe market was going to continue to move in my direction and that Ishould definitely not get out yet. So I didn’t. Two weeks after that,my $5,000 was down to about $300. I concluded that instead of overtrading,my mistake was not getting out while the getting was good.A few accounts after the option debacle, I had ventured into tradingoption spreads. I had been tracking OEX (Standard & Poor’s 100Stock Index) option time spreads. You would buy the near month optionand sell a deferred month and profit off the decay of the deferredmonth with protection. After tracking these for awhile, I spotted atremendous opportunity in the British pound options. I noticed a hugediscrepancy in the price of the near month option against the price ofthe deferred month’s option price. After much calculation on howmuch I was going to make off this trade, I decided to place 20 spreadswith my $7,500 account. I knew that my risk was limited and that Iwould not be charged more than the difference between the two optionsfor margin. Too bad my broker didn’t know this.A few days later, the broker called me and left a message statingthat I was considerably undermargined. Thinking that this was a mistake(and because I was actually making about $100 on each spread), Ididn’t bother calling him back right away. A few days after that, I hadnearly doubled my money with the trade and decided to get out notwanting to repeat the mistake I had made with the crude oil options.So, I called the broker and exited the position at the market. I learnedseveral important lessons that day. First, British pound options arenot very liquid. Second, a September British pound option is based onthe September contract of the British pound. A December Britishpound option is based on the December contract of the British pound.Third, full margin is charged in this situation.Instead of making $7,500 on the trade, by the time I closed bothends of the trade, slippage brought me down to actually netting anegative $500 on the trade. When I added in the slippage and $35 perround turn-40 of them-1 lost about $2,000 on the position thatsupposedly was making me close to $7,500!Next, I was chewed out for not returning the call regarding themargin deficit. I was informed that I was being charged full marginfor the short sell of the options because they were on the Decembercontract and therefore were not offset by the September option purchase.They were about to liquidate my position with or without myconsent (rightfully so, I might add).Even though I had placed far too many British pound optionspreads in that account, I did not learn about overtrading the account.This little lesson eluded me until I analyzed why my straight futurestrading took me to over $20,000 in four months and down to less than$2,500 in two weeks. Not being absolutely certain of my conclusion, Idid a little research on the subject.This was a major turning point in my quest to succeed at trading.I picked up a book called Portfolio Management Formulas, by RalphVince (New York: John Wiley & Sons), and was stunned by one of theexamples in that book. Even though the book is highly technical andimpractical for most traders, it does an excellent job of revealingthe importance of money management. The following example fromthat book confirmed my original conclusion that I .had simply overtradedmy account and also illustrates why traders need proper moneymanagement,Take a coin and flip it in the air 100 times. Each time the coinlands heads up, you win two dollars. Each time the coin lands tailsup, you lose only one dollar. Provided that the coin lands heads up 50percent of the time and tails up the other 50 percent of the time andyou only bet one dollar on each flip of the coin, after 100 flips, youshould have won a total of $50.