Cash Management and Dynamic Asset Allocation for Active Stock Traders

Cash is the lifeblood of trading. Lose your cash and you lose your chance to participate in any future opportunities. Opportunities come and go, but once your cash is gone, it's GONE. Your number one goal, therefore, is asset preservation. As Alexander Elder put it: "If you take care of the losses, profits will take care of themselves."

Stay liquid

Always have cash on hand for the next opportunity. That means moving in and out of stocks as circumstances warrant.

Cut losses ruthlessly

Never lose more than 10% on any one position. The first loss is always the best loss. Sitting in a dud that's underwater hoping it will recover clouds your judgment and prevents you from taking advantage of new opportunities. This does not mean that if you are down only 5 or 8%, you should stay put. If the stock is not moving while the market is powering higher - sell. Waiting to break even is a loser's game that will never make you any real money.

Limit your position size

No one position should hurt you materially. There are several ways to determine your maximum commitment per stock:

- Never risk more than 2% of capital. If you have a $100,000 portfolio and cut your losses at 10%, your maximum position size is $20,000.

- Every person has a pain threshold denominated in dollars. If you can't stand losing more than, say, $600 per trade, and you cut your losses at 10%, your maximum position size is $6,000, regardless of the size of your portfolio.

- "Sleep well at night" or "I don't care" position size: if a position keeps you awake at night or makes you worry constantly, sell down to where you can sleep and leave the position alone.

Number of positions

If you keep your position size constant, the market will decide how many positions you carry. In a good market, when multiple stocks are breaking out, you will be fully invested and even on margin; in a bad market you will be largely in cash. This way you will only own the best stocks at all times, regardless of the number.

Asset allocation

The larger your trading account, the less risk you have to take to produce the same amount of profit. But it still makes sense to limit the amount of capital you put at risk.

Let's say you have a $100,000 portfolio. You could put all of it in a diversified stock fund for a 10% annual return, but your entire portfolio is at risk. As the recent bear market showed, the downside could still be as much as 50%. 10% upside; 50% downside - not good.

Instead, you could allocate $25,000 to aggressive stock trading while keeping $75,000 in CDs and/or Treasuries. This way you only risk 25% of your portfolio. You could aggressively trade up to $50,000 on margin, aiming to double your money. 100% on $25,000 (50% on $50,000) is 25% return on the entire portfolio. Now your upside is 25%+, while your downside is less than 25% if you follow the above selling rules. Much better.

Or you could put the $100,000 in a mutual fund and trade stocks on a 20% margin. Knowing that you are trading borrowed money will keep you on your toes and limit your stock exposure to exceptional opportunities. If you buy a junk-bond fund yielding 10%, the interest you earn will more than offset the margin.

Keep your trading account size constant

Make a habit of transferring a part of the realized profit out of your trading account. This will prevent complacency or arrogance from setting in. Increase the size of your trading account as your confidence and profitability grow.

Keep a 3-6 months cash reserve at all times

The bulk of your trading profits will likely come from 3-5 lump sums per year. You need the time to get there.

If you don't have an adequate cash reserve, gambling your mortgage money will either paralyze you or make you take unacceptable risks.