A way to look at  money management and positionsizing techniques  trading stocks

Being a discretionary trader in stocks as opposed to a systems trader often is equaled to not being systematic. Although discretionary trading leaves the trader with greater freedom to use intuition and experience the core approach or the plan can and should be systematic. The tradingplan much like a business statement should deal with all aspects of trading from practical issues to trade management. The phrase ”plan the trade – trade the plan” has many depths and focuses on the business aspect of trading which has the added bonus of detaching the feelings involved in trading. The decision to trade becomes a business decision rather than a personal ”Am I right or wrong”-decision.

A way to incorporate a systematic approach towards money management and positionsizing while still leaving room for intuition and experience and staying discretionary is to use the Torssell/Nilsson Money management matrix. The Matrix should be used as a tool pointing towards a certain direction. It does not dictate the final strategy to be chosen. Many different aspects must be considered like how current volatility affects money management parameters, diversification, overall exposure/risk etc.

Entry is often given much attention in the litterature while not much emphasize is placed on the much more important questions of money management, positionsizing and how to exit with a profit. To give a quick answer to the question of what to focus on for a particular trade the Torssell/Nilsson Money managemnet matrix can be helpful. The Matrix tells the trader where among different money management strategies to look and also deals with the issue of positionsizing.

The rationale behind the Matrix is that it is not always best to let your profits run, and by the same token it is not always best to use profittargets. The market should dictate what is best. If the market is trendless perhaps the trade should not be given the same opportunity to prove itself as when the market is trending. If a position is placed against the prevailing trend the trade could have good probabilities of succeding, but perhaps a profittarget should be employed more often then when trading with the trend.

Focusing on stocks it is often stated that 7 out of 10 stocks move with the general market. It is not hard subscribing to this notion. When the trend is up something in the economy is probably good and it is affecting a large array of companies. When the trend is up psychology of the crowd is at its best and buyers are positive. Therefore the first variable in the matrix is the general market as measured by a broad index. A simple moving average approach is used to determine wheter the trend is up, down or if the market is trendless. If for instance the 20- and 50-day simple moving averages are pointing in the same direction the market is trending that way, up or down. If the averages are not in sync the market is sideways or trendless. Many other ways to determine trend can be used. The simple approach of using higher peaks and troughs for uptrend and vice versa for down trend works just fine. It is left to the trader to make this choice.

The second variable to focus on is of course the stock itself. The same three possibillities are looked at. Is the stock trending up or down, or is it moving sideways.

This results in nine different possibilities as suggested by the Torssell/Nilsson Money management Matrix:

When considering a long trade

Within every cell the answer of what to focus on when it comes to money management and positionsizing is given. The suggestions are (when looking for long trades):

If the market and stock both are trending up or one of the two is sideways while the other one is trending up focus should be placed on trying to ride winners and letting profits run. The trend is with us and focus should be on trying to exploit the trend, not secondguess when it is about to end. Trailing stops based on historical volatility, ATR etc would be a way to do this. Positionsizing should be more agressive in a anti-martingale fashion. When both the stock and the market is trending up perhaps pyramiding should be considered.

If the market and stock both are trending down or one of the two is sideways while the other is trending down and for whatever reason a long position is considered focus should be on a more aggressive profittaking approach. Pick a target perhaps based on a multiple of the ATR or resistance area and exit half the position. Put in a break even stop on the rest of the position and trail it from there. If both trends are down perhaps it is wise to only use a profittarget. Positionsizing should be conservative, only place small bets also in the anti-martingale spirit. 

If the market and the stock is moving sideways or the trends are in different directions. Something may be about to happen. If the market is moving up and the stock down, it might be that the stock is about to play catch-up with the market and reverse its trend. In this scenario it would be wise to take profits on half the position based on initial risk (”2 for1” approach by L. Connors) or a target based on resistance areas. The remaining part of the position is protected with a trailing stop. Position sizing is kept neutral.

When focus is on short trades the matrix is reversed.

Position sizing in the Money management matrix suggest a rather simple approach. Being aggressive could mean risking 1,5% of equity, neutral meaning 1% and conservative 0,5% of equity. The position sizing issue within the framework is overlysimpified and should be given more thought. Total riskexposure must for instance be considered.

The concept can be widened easily by incorporating different kinds of trends, for instance strong, neutral or weak. Employing a simple tool like the ADX or slope of the moving average would do this. Further exploration is left to the reader.

The Torssell/Nilsson Money management matrix gives the disrectionary trader a systematic approach towards money management technique selection based on what the market and stock is telling us. It does not give the final answer as to what approach to use, it merely hints in a logical direction.