The secret I’m going to share with you today is probably the single most important factor in determining the success of stock market traders. If you can master it, you can make millions in the stock market.
This technique is simple, but it requires months of training and dedication to master. The trouble is, it goes against our basic emotional conditioning. Don’t worry if you don’t get it immediately. Keep practicing…
So what’s the secret?
The amateur thinks winning in the market is about predicting the future. The amateur buys some shares and hopes the market rises. He has no idea what to do if something unexpected happens. He wings it completely and ends up trading with his emotions. There’s nothing more destructive to wealth than emotional trading.
The market is a game of probability. It has nothing to do with predicting the future. When you treat the market as a game of probability, money management becomes your most important weapon. What I mean is, the stocks you buy become far less important than the position size you use and the decisions you make after you pull the trigger.
This is the secret to beating the stock market. Maybe one speculator in 1,000 knows this. Until you realize this, you have hardly any chance of making money in the market. It boils down into three easy rules…
Trading Rule No. 1: Risk a constant amount of capital in each trade… and keep it small.
Most investors put more money into their favorite ideas than they put into their least favorite ideas. They have no system for figuring out bet size.
Skillful traders know they can’t read the future, so they give every bet the same chance. They make thousands of small but profitable trades and accumulate their fortunes slowly but surely. The key is to keep your bets small and constant by putting, say, 2% of your total trading capital in each trade.
Trading Rule No. 2: Cut your losses. You are trading against some of the world’s smartest people, armed with incredible research budgets and advanced supercomputers. They don’t trade as a side job or as a hobby. These people live, eat, and sleep the market.
The market is a hostile place. It’s like a medieval army trying to get into your castle day and night. Your stop losses are the castle gates. A position without a protective stop loss is like an open gate. You’re letting the army pour in and take your gold.
To control your losses, use a stop loss. This way you know exactly how much money you stand to lose if your stock falls, before you’ve even entered the trade. The stop loss applies at all times and can never be overridden.
Trading Rule No. 3: If your trading idea shows a profit, add to your position. If it keeps rising, add more. For example, begin your investment with a purchase of $2,000. Once your stock is up Y%, invest another $2,000. Then, once your stock is up Z%, invest another $2,000, for a total cash investment of $6,000. Decide what Y and Z are before you enter the trade. Write them down so there’s no confusion.
I have a mantra that captures the essence of this secret. We call it “doing more of what’s working and less of what’s not.” This mantra drives every decision we make.
By using these three simple money management techniques… that is, push your profits, cut your losses, and keep your positions small and constant… you can beat the market, too. You won’t win every trade, but in the long run, you’ll generate a positive return in your trading account.