Papale on Trade Management

By Steve Papale

Spring Break.  The annual rite of college students and families alike.  For us it is next week.  This year it is especially welcome – but I think I say that every year.  This winter was cold and long – we had 4 inches on snow two days ago and today we are in the 30’s!  But soon enough it will be 90 and muggy in Chicago.  And we will be complaining about that.

Trade management can be broken down into two areas – risk management and money management.  While they are closely connected there is a definite difference.

Risk management is how we enter and manage the trade.  It involves the calculations we use to determine our profit and loss targets and our adjustment points.  It further helps us structure and place the trade.  Risk management has nothing to do with the size or dollars in the trade.  It is purely a quantitative determination based typically on statistics and percentages.  For example, we might place a butterfly and make an adjustment when the price gets to X.  Our profit target could be 10% on half and 20% on the other half.  We would close out the trade if the loss reaches 25% or there are only 5 days left until expiration.

Money management on the other hand deals with sizing and allocation of the trade.  It takes into account the risk aspects of the trades such as potential draw-downs and performance correlation and then determines the dollars to each trade or strategy.  For example, we might allocate 25% of our account to strategy A, 20% to strategy B, 30% to strategy C and 25% to cash.  Once we determine the risk and money management guidelines we then have a trade plan we can work from.

These two areas – risk and trade management make up the blueprint we will follow consistently going forward.  Not to say we would never deviate from it.  There are times of extreme volatility or draw-downs where we might adjust either the risk or money management portion by cutting back size or even tightening stops in some cases.  But month in and month out we follow our carefully thought out trade plan until results direct us to do otherwise.

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