It is always tempted to allocate all your capital on a trade or trades that you “believe” is/are technically and fundamentally sound. However, next time when you have this temptation crossing your mind, make sure you don’t fall for it. Remember the old saying, “Don’t put all the eggs in one basket”. It is always easier to say than done. That is why we need to use a system to help controlled/ managed our emotions, so that if the basket drops, you don’t lose all your eggs.
This saying has a slight different meaning when applied to our trading system for capital management. At any given time, I never allocate more than 70% of my capital (eggs) on a stock position or positions. The remaining 30% capital is set aside as a reserve for a critical moment. As you venture longer into the stock trading profession, you will eventually realize the importance of this 30% of your “eggs”. This could also be applied to your personal financial planning. We should always put aside some capital for emergency needs.
Recently, the critical moment came when the market dropped violently on Monday, August 24th. I was stopped out of all my longs, but I did have the shorts to help offset this nasty gap down (the beauty of pair trading). My system gave out fresh buy signals on several strong stocks (NFLX and UA for illustration) that I followed on the day prior (the 21st). The trade is to buy the next trading day, which is Monday, the 24th.
If you did not sell when your stop hit and you were fully invested, meaning that you were out of capitals when the opportunity showed itself, you would be beating and screaming at yourself why you did not have more “eggs” to work with. It is by then, you would be able to comprehend how important the other 30% of your capital is.
Respect your stop loss! Sometimes, you have to give up a loss in order to gain a profit. To rephrase, only if you take your stop loss that you will be able to release your capital, in addition to the 30% reserve, to work with on new trades that will come along.
This capital management technique can also be helpful when facing hard choices. Remember, you let go of one thing so that you can have room for other things in life.