direction, the option will decrease in value and expire worthless. Your loss on the option will be the premium you paid to acquire it. You need to take that into account when formulating your stop strategy. You do not want to pay too much for the option and you want to use the closest expiration date if you are trading short term. If you are a long-term trader, perhaps you will need to go out several months to protect yourself If your initial analysis is wrong and the market sells off, you can recoup some or all of the loss that occurred.

Another good technique for use with options is to lock in a profit. Suppose you are long from a price of 500 and the market is now at 600. You can place a sell stop at 550 and sell a 550 call naked (all by itself), receiving the premium as payment. If the market falls below 550 you exit your futures position, the option becomes worthless, and you made a profit (550 - 500 plus the premium). If the market continues to rally and stay above 550 past expiration date, you lose your futures position to the option holder for the strike price of 550, but you still made a profit (550 - 500 plus the premium).

These are just two simple strategies you can use with options. There are numerous strategies, both simple and complex, that can be used with options.

Conclusion

Exiting a position is an important aspect to trading. If you cannot properly exit a position, you will never achieve success in trading. Exiting is more complicated than simply picking up the phone and calling your broker. A proper exit strategy is crucial in preserving your capital and ensuring profitable trades. Once you enter into a position:

• You have to set your initial stop. You will need to determine your risk parameters and examine the type of market and trade you are in. Will this trade last three days or three weeks?

• Once the initial stop is placed, you will then need to monitor the position. When is the appropriate time to bring your stops to breakeven?

• Determine if you will take a predetermined amount out of the market or if you will trail the market until you get stopped out. If you decide to use a trailing stop, you will have several to choose from.

Once you are stopped out of the position, hopefully with a profit, the whole process starts over again with the next trade. This chapter has highlighted the importance of stops and a proper exit strategy. There are numerous techniques, and you will need to experiment and use the ones that you find most comfortable. The techniques you use should make sense to you and your style of trading.

Basic Money Management

Joseph Luisi

The key to any successful trading venture is money management. It is probably the single most important aspect in trading. Money management can be loosely defined as how a person manages his or her money in the financial markets, the persons bankroll so to speak. This can consist of factors such as the number of contracts to trade, the number of markets to trade in, exiting a position, and loss control. Money management can be as simple or as complex as a trader wants it to be. In this chapter, we will start with the basics of money management and move on to more complex topics. Each idea or topic will show how you can apply money management to your trading to help ensure your success.

Money management has been one of the least understood aspects of trading. For this reason, it is also the most essential to master-without it, failure is imminent. In its most basic form, money management in trading means that traders should spend 70 percent of their time on developing and using money management and 30 percent of their time looking for low-risk, high-profit trading opportunities. In contrast, many traders feel that a successful system can make them rich without regard to money management. Many systems can be 80 percent accurate and still lose money due to overtrading and bad risk-to-reward ratios. By risk-to-reward ratio, I mean a system that has 9 profitable days in a row making $100 a day can be wiped out on day 10 with a $900 loss. The system is 90 percent accurate, yet no money is made. To be successful, a trader only needs to be accurate 51 percent of the time and sometimes not even that. Most successful money managers use systems that are only 40 percent to 50 percent accurate, but they have very strict money management standards and their risk-to-reward ratio is \ very high. Having a money management plan is critical. All the top traders interviewed in Market Wizards, Harper Business, 1993, by Jack Schwager had a reason for stating that money management is the most important element in trading. It is!

The Basic Terms

The following terms are used in this chapter:

• Average loss The total of all your losses divided by the total number of losing trades.

• Average profit The total of all your profits divided by the total number of winning trades.

• Capital The amount of money in your trading account at any given time. This can also be referred to as equity.

• Drawdown This represents a cumulation of losses from your last winning trade. Drawdown can be measured on an intraday, daily, and end-of-trade basis. A series of losing trades can accumulate into one large drawdown.

• Equity Represents the profit or loss on a given trade, added to the previous equity value. Generally, the trader starts with an initial equity amount of $ 10,000 and as trades are taken or followed, the outcome profit or loss is added or subtracted to the initial equity and a running total is kept. For example, if trade results were +100, +200,-100, and +300 for a starting capital of 10,000, the equity after each trade would be 10,000, 10,100, 10,300, 10,200, and 10,500.

• Fast market A market in which the action (prices) are moving wildly, usually after some surprise news or economic report is released. During this time, the brokers on the floor are not held to your orders at the price you give. Now you can see why slippage becomes an important factor.

• Gross profit/loss The total profit or loss from a trade not including commissions and slippage.

• Largest losing trade The biggest dollar-losing trade compared with all losing trades in a given series or number of trades.

• Largest winning trade The biggest dollar winning trade compared with all winning trades in a given series or number of trades.

• Limit Move The maximum that a market can move up or down in a single trading day.

• Losing trade A trade that produced a loss once a trade is over.

• Margin The amount of money a trader needs to put up to trade one contract of a particular market. This amount is set by the exchanges and can be changed.

• Net profit/loss The total profit or loss from a trade including commissions, slippage, and any other factors included in your exit price.

• Percent losing trades A running total of the number of losing trades divided by the total number of all trades.

• Percent winning trades A running total of the number of winning trades divided by the total number of all trades.

• Slippage A term used to define the difference between the price you get on a trade versus the actual fill from your broker. This usually represents a few ticks. In fast markets, it can become many ticks. This can be important when comparing results on paper versus actual market results. The two can be very different.

• Starting capital The amount of money used to start your trading account.