The goal of effective trade management is to keep losses as small as possible while preserving the opportunity to realize large gains.
The challenge is that it is always a series of tradeoffs.
If we push too hard to avoid even a minor loss then we will be shaken out of good trades at the wrong time and miss out on the upside. If we give a stock too much room then we risk uncomfortably large losses if the trade is a dud.
Always at the Mercy of Price Action
When designing a trade management system there are two key issues to keep in mind.
The first is that no system is perfect. There will be times when you close out a position at the exact bottom and there will be times when you will buy at the exact top. It is the nature of the beast. It is impossible to avoid suboptimal results at various times. The market is constantly undergoing changes and what works best will vary greatly depending on the character of the market action.
The second issue to keep in mind about trade management is that our ability to predict the future is extremely limited. Once you embrace the fact that we really do not know what a stock might do after we buy it, it is easier to understand the great value of a trade management system. We cannot count on our "homework" to predict what a stock is going to do. We will always be at the mercy of price action no matter how confident we are about fundamentals or other matters.
When we pick a stock to buy we are hopeful that our fundamental and technical research is correct but, very frequently, we will be wrong. Research will help us find stocks but trade management is the way to make sure that they make us richer and not poorer.
The simplest form of trade management is to make a single buy of stock at a certain price and at the same time set a stop that will keep any loss to a certain small amount, such as 5%, 8%, 10%, etc. The longer your time frame the more room you will likely give a stock to the downside. Also, if a stock is particularly volatile (this is technically referred to as high beta) it may require looser stops so that the position isn't sold due to normal movement.
Typically, someone who employs this method will move the stop up as the price rises. This is called a trailing stop and can serve as a good way to eventually lock in gains. However, the challenge is to always keep the stop close enough to protect gains but not so close that the stops are triggered due to normal volatility.
That is the general theory behind all money management systems. Once you fully understand and internalize the primary goal and have developed the discipline to apply a set of rules, then the next step is to modify the system to reflect your particular style of trading.
An Incremental Approach
The first enhancement that I recommend is to use an incremental approach. Rather than make a single buy and single sell, you look to make multiple buys and multiple sells with a variety of stop levels and profit-taking rules. This approach goes hand-in-hand with embracing the idea that our predictive abilities are limited. We will seldom buy and sell at the exact right time so rather than attempt the impossible we average into a stock and hope that with a series of buys we will end up with a better average entry price than if we just made just one single buy. That won't always happen but it increases the odds.
One of the big benefits of incremental buying is that it relieves the pressure to be overly precise. It is much easier to enter a stock when you gave yourself room to add lower or higher as it develops.
The same theory applies to the exit. We can hope we sell at the precise top but if we make several partial sales instead, then the chances are that are average exit price will turn out to be higher.
It is easier to be patient with a strong position when you can lock in some partial gains along the way. Selling too early is one of the most common mistakes traders make and it is easier to battle that urge when making partial sells.
When you employ a money management system of this sort, trading becomes much more strategic. It doesn't matter if the trade works immediately or not and it doesn't matter if you make some poor entries and exits from time to time. Overall if you have picked a good stock, you will enhance your ability to rack up some good gains while minimizing losses if you embrace volatility rather than fight it.
By no means is this an easy job but over time you will learn to internalize the skill of strategic trading rather than a buy-and-hope strategy. Good traders can make money even with poor stocks if they use an effective trade management system. Your confidence will grow when you find a good system and that is how you produce big gains.
This is just the tip of the iceberg when it comes to trade management but the first step is to have the right mindset and a basic system. Once you master that then you will be on your way to becoming a strategic trader.