Two Simple Rules That Keep You In The Trading Game
December 15, 2008 by Vagabond Investors · 2 Comments
Money management and position sizing are probably the most misunderstood concepts in trading. We have only two goals in every single trade we make.
1. Make money
2. Learn
We can’t do both every time but for sure we should get at least one of them.
In my early days of trading I wasn’t aware of the importance of solid money management. In my opinion, it pays big money to take it very seriously. Money management keeps us in the game. It makes sure that we don’t get lethally hurt in any trade. I’ll run you through one simple and easy-to-use money management system, which I have used for several years.
The Rule Of 2%
The rule of 2% simply says that you never risk more than 2% of your trading account capital in one trade. I always – and I do mean always – follow this rule. If 2% seems a lot, I don’t have to ever risk that much if I don’t want to. I might choose to risk 0.5%, 1%, 1.5% or 2%. I never ever risk more than 2%.
So what does this mean?
Let’s look at an overly simplified example. Let’s say we have $100,000 in our trading account. We have found a very attractive trading candidate. We decide to enter this trade. The stock trades near its support level at $15.38. We figure out that a suitable stop-loss level would be at $14.12. Following the rule of 2%, how many shares do we buy?
The maximum loss we are willing to take is $15.38-$14.12=$1.26. On the other hand, 2% of our trading account of $100,000 is $2,000. We divide $2,000 by $1.26 (per share) and get 1,587 shares. Always round the number down never up. Include your brokerage fees and possible slippage in the 2%. So we decide to buy 1,500 shares.
One more thing we want to do here. We check that the total amount we put in the trade doesn’t exceed 25% of our total account. That would be $25,000 in this case.
The rule of 2% applies to any single trade I make. That’s very important. There’s another vitally important rule I wish to stress here.
The Rule Of 6%
The rule of 6% applies to my total open risk. It says that I never want to have more open risk positions than 6% of my trading account capital at the time. In other words, before I enter a trade, I check that my open positions in this new planned position don’t exceed $6,000, which is 6% of my $100,000.
Whenever the value of my account dips 6% below its closing value at the end of last month, I stop trading for the rest of this month.
Putting It Together
Here’s the idea of these rules. The 2% rule will keep me out from disastrous losses while the 6% rule will keep me out of long losing strings. Will I miss some fabulous opportunities as I follow these rules? Sure. It’s still vitally more important to follow the rules. Why? It keeps me in the game in the long run. It pays to have rules that keep you in the money tree year after year.
Let’s look at an example. Let’s say I make 30 horrible trades in a row, each of which loses the maximum following the rules I outlined above. I will still easily manage to protect over 55% of my trading capital.
|
Account |
MAX Risk |
Account |
MAX Risk |
Account |
MAX Risk |
||
|
100 000 |
2 000 |
81 707 |
1 634 |
66 761 |
1 335 |
||
|
98 000 |
1 960 |
80 073 |
1 601 |
65 426 |
1 309 |
||
|
96 040 |
1 921 |
78 472 |
1 569 |
64 117 |
1 282 |
||
|
94 119 |
1 882 |
76 902 |
1 538 |
62 835 |
1 257 |
||
|
92 237 |
1 845 |
75 364 |
1 507 |
61 578 |
1 232 |
||
|
90 392 |
1 808 |
73 857 |
1 477 |
60 346 |
1 207 |
||
|
88 584 |
1 772 |
72 380 |
1 448 |
59 140 |
1 183 |
||
|
86 813 |
1 736 |
70 932 |
1 419 |
57 957 |
1 159 |
||
|
85 076 |
1 702 |
69 514 |
1 390 |
56 798 |
1 136 |
||
|
83 375 |
1 667 |
68 123 |
1 362 |
55 662 |
1 113 |
Following these rules protect your capital. It gives you time and possibilities to learn from your trades. It gives you time to develop your trading system and setups. Combine this with a good record keeping and you will become a successful trader.
Although investing is one of my greatest passions, there are more important things in life than money. Personally, I’m about to have some more fun with my wife and daughter here in Thailand. I wish you all Merry Christmas and a Happy New Year!
Matias
How Banks Work: Money Creation Leads To Inflation
December 9, 2008 by Vagabond Investors · 6 Comments
How Banks Work
Let me tell you in overly simplified terms how banks work. Banks make money by making loans. Depositors put money into the bank and the bank lends the money out to a borrower. The banks charge a higher interest rate on the borrower than the rate it pays to the depositor. This difference is known as spread.
Banks can lend more money out than they have. In other words, they can lend out money that they don’t actually own. What? Yes. Let’s see how that works.
Money Creation
How much they can lend depends on the reserve required given by the central bank (for example, the Federal Reserve). This is typically 10%. A low reserve rate magnifies the amount of money banks make from lending money. The fact that banks don’t have to keep 100% reserves but only a fraction of that is called fractional reserve banking.
Suppose you deposit $10,000 in your account. The bank has a reserve ratio of 10%. It has to keep 10% of your deposit or $1,000. It is free to lend the rest 90% or $9,000 at interest. The person who borrows it will spend it somewhere and the money ultimately gets deposited again. From that new deposit of $9,000, the bank again keeps $900 and lends $8,100. This process is repeated over and over. Each time the bank gets money, it keeps 10% and lends out the rest at interest.
This process is repeated as many times as possible. Ultimately your $10,000 can become up to $100,000 in the overall money supply. You can calculate this by dividing the initial deposit of $10,000 by 10%. The total money supply of in the economy increases as banks make loans. Therefore, for every $1 that is deposited, up to $9 new money can be created on top of it. This process is called the money multiplier.
It works with the Federal Government as well. The government wants to borrow $10 billion. It prints bonds and gives them to the Fed. The Fed in turn prints $10 billion worth money and gives it to the government in exchange of those bonds. It was all created out of thin air. The government then deposits this money into a bank. The bank keeps 10% or $1 billion of this in required reserves. It has an excess of $9 billion in reserves which is lends out. Here’s the twist:
The Federal Government borrowed $10 billion
The bank holds a fractional cash deposit of - $1 billion
The bank lent out the rest = $9 billion
Now, it is important to recognize that the $9 billion is created on top of the $10 billion. It comes on top of the existing money supply. Where did that new money come from? It was created out of thin air because of the fractional reserve system. New money comes into existence in loans.
This creates an interesting outcome.
Inflation
When a person needs money, it borrows money from the bank. The bank lends the person the money. That money is debt. The loan principal has to be paid back with interest. Almost every single dollar must be paid back with interest as well. The interest must come from the existing money supply.
But wait a minute! All money comes from central banks. It is expanded by commercial banks through loans. The principal is the money supply. Where is the money that is needed to cover the interest?
It doesn’t exist. It needs to be created.
In the economy, the money that is needed back to the banks (principal + interest) will always be more than is available in circulation. New money must be created to cover the interest. An increase in money supply leads to inflation.
This is why inflation is a constant in the economy. Money is debt. The game of modern capitalism is: Who is indebted to whom? In times of inflation, savers are losers and debtors are winners.
As an academic side note, which is almost too boring even for me, I know that some of the people reading this are keen to point out this: Inflation is actually an increase on the money supply and that it is the increase that leads to higher prices. Inflation is the devaluation of the currency and leads to higher nominal prices. I am aware of that. For simplicity’s sake, we will define inflation simply as higher prices. In other words, the money is worth less. Things cost more.
The Fed Creates Inflation
Who is in control of the money supply in the United States? It’s the Federal Reserve. Interestingly enough, the Federal Reserve is accountable to no one. It has no budget. It is subject to no audit. Nobody can truly supervise its operations. It is in almost total control of the nation’s money supply. Yet its chairman Ben Bernanke was never elected by the general public and he thinks that printing money at will is a good idea. It may be, but for whom?
The fact that it is accountable to nobody is trumpeted as a virtue. Still, it is the Fed that is responsible for money creation and thus creating inflation. They’re happy to create $700 billion out of thin air to bail out their banker friends in Wall Street and more, much more is on the pipeline.
Who Pays The Price?
Who pays the price in taxes? Who’s left out dry with the upcoming inflation from that money creation? Who gets the short end of the stick?
It’s the taxpayer. It’s the average Joe Blow on the street. It’s you and me. Such is life and it’s getting sucher and sucher all the time.
Get Educated
That’s why getting financial education is so important. Unfortunately, you don’t get it in school. We have dedicated this website for your future. Please take the time to educate yourself and learn how you can ride the upcoming inflation waves instead of be run over by them. You can survive and profit handsomely, if you know the rules of the game.
So how do we survive? How do we profit? Which asset classes thrive on inflation?
Let’s look at that in the upcoming posts.
Jaakko
Dare to Dream: Aim Higher, Much Higher!
December 5, 2008 by Vagabond Investors · Leave a Comment
Only one out of hundred people think that they can achieve something extraordinary. This, of course, has nothing to do with the fact that most people have within themselves the capacity to something much larger than their present reality suggests. The majority of population chooses to settle to mediocre results. This is because their goals are not big and exciting. If we dream only of small and achievable things, we are not willing to make the necessary contributions to make things radically better.
I have found that small goals are not exciting enough to generate the kind of momentum that is needed to solve any problem and go through any uncomfortable challenge. I need something big, completely unrealistic that would change the quality of our lives to a completely new level. The results have to be worth the effort. I’m willing to sacrifice my feeling of comfort, some time and capital to create something outstanding. We need to be a bit naïve to do this.
It seems that there is less competition when we’re after big things. 99 % of people focus on playing it safe and small. It is much, much easier to acquire €100,000 financing for a deal than €10,000. €10,000,000 is more reachable than €1,000,000. Similarly, it’s easier to get a date with one 10 point beauty in the bar than trying to get five 8’s. Most people don’t even dare to approach the 10 point lady. That eliminates most competition right there. At the same time, there’s more flirting work to do with five ladies than focusing on the perfect one. In addition, all the other guys are there too. So aim high! Be grateful for whatever it is that you get.
Everything was possible, when we were kids. If we wanted to be astronauts or pilots, nobody told us it was impossible. Our mommy and daddy said that we could be anything we wanted to be. We were invincible. In the same way, our parents seemed flawless and their capabilities were limitless. Everything was possible for them. So it would be for us when we grow up, right?
Not quite. At the edge of adulthood we learned to be realistic and to listen to other people’s depressing comments. We learned to believe in our own smallness. You don’t need much to survive. In Finland there’s this saying that states that those who try to reach high ultimately fall to the ground. The fact is this is just a coward’s cry. We try to bring our loved ones to the ground because we don’t dare to try reach our dreams.
Don’t get me wrong. I’m not saying that more is always better. I’m saying that life can be about excitement, growth and possibilities! Each one of us chooses the things that are most important in our lives.
Wake up our inner child. Dare to dream. Dare to get excited! Get excited of your possibilities and visions. Don’t worry if it’s possible or not or how you’re going to do it. Just get the feeling! Spend 15 minutes dreaming of the most thrilling things you can possibly imagine. You might even write it down and clip pictures out of magazines and put them where you can see them.
What could you dream of? Traveling around the world? Paragliding in Pery? A business meeting in a private jet? Your own island? 10 schools for the children in Africa? Go for it!
Get the feeling. There’s nothing wrong with dreaming. Even though you never reached a single one of those dreams in your lifetime it’s still better to be excited of things that you love inside than living a life of quiet desperation.
Live with passion!
Matias
Parody Video: Hitler Faces Foreclosure And Wants To Be Bailed Out
December 5, 2008 by Vagabond Investors · 1 Comment
Hey all,
Somebody had a brilliant idea to make a video parody of Hitler as a real estate flipper. He bought a house to flip, faces foreclosure and wants to be bailed out.
I watched it and laughed my butt off! I’ll post it here for you to see. Enjoy!
Jaakko
The Seven Levels Of Investors
December 1, 2008 by Vagabond Investors · 1 Comment
A few weeks ago as I was traveling to hold a seminar I reread some of my old business books on the way. I came across Robert Kiyosaki’s “Cashflow Quadrant” (an excellent book, which I remember knocked me out mentally years ago). I’m going to reiterate an excellent point in the book. I highly recommend you buy and read the book carefully from cover to cover.
The Seven Levels Of Investors
Level 0: Those with nothing to invest. These people have no money to invest. They spend all they make or more than they make. About 50% of adult population is on this level.
Level 1: Borrowers. These people solve financial problems by borrowing money. They’re not conscious of their spending habits. They may have some assets, but their level of debt is simply too high.
Level 2: Savers. These people save small amounts of money in low-risk, low-return vehicles such as a CD. They often save to consume rather than invest. They have a deep need for security. They’re afraid of debt and pay in cash. People in this group waste their most precious commodity, time, trying to save pennies instead of learning how to invest. In times of inflation, they end up as losers.
Level 3: “Smart” investors. These are educated intelligent people. However, when it comes to investing, they’re uneducated. Some of these people have convinced themselves that they don’t understand money and never will. Some are cynics. They sound intelligent but are really cowards under their intellectual exterior. Others are gamblers who think that investing is like Las Vegas. It’s just luck. They have no rules or principles and often lose it all.
Level 4: Long-term investors. These investors have a clearly laid out long-term plan that will allow them to reach their financial objectives. They get educated before actually buying an investment. If you’re not yet a long-term investor, get yourself there as quickly as you can. Keep it simple. Forget sophisticated investments. Put some money down and start small. This level is where most of the millionaires in America come from. Live within your means, minimize your debt and incrementally increase your assets. You don’t have to be great to start, but you have to start.
Level 5: Sophisticated investors. These people have more aggressive investment strategies, because they can afford them. They have good money habits and have a long track record of winning. They have a solid foundation of money and conservative investments. Their debt-to-equity levels are under control. They put their own deals together. They are clear on their own principles and rules of investing. They reinvest their gains and hold their wealth in legal entities such as corporations.
Level 6: Capitalists. Very few people reach this level of investment excellence. These are the movers and shakers of the world. Their purpose is to make money by orchestrating other people’s money, other people’s talents and other people’s time. They usually have large businesses and large investments. True capitalist create investments and sell them to the market. They love the game of money and are generally very generous. They think that money is not a thing but an idea created in their head.
What level of investor are you?
What level of investor do you need to be in the near future?
Remember, anyone with the goal of becoming a level 5 or level 6 investor must develop their skills first as a level 4 investor. Level 4 can never ever be skipped. Anyone who tries to skip it is actually a level 3 investor – a gambler!
As I approached the city I was going to give my speech, I was thrilled. Something so simple and so profound reminded me of how important it is to be clear on your current level and objectives. Needless to say, I was more than inspired to give my speech.
Jaakko
