If you are trading on margin, cash management is a very important part of your trading. If you over-trade your account, you are doomed to lose money.
Even if you trade in your IRA account cash secured puts and covered calls, and you can theoretically go full in, I still recommend applying rules mentioned below.
When trading a margin account, the account buying power can fluctuate a lot. One day you will see your Net-Liq a hundred percent up, the next day it will look like you are going to bankrupt.
And you can for sure get into trouble if you over-trade your account and do not respect your cash management rules. Then devastating margin calls can come.
In a margin account, you have two options:
1) Ignoring margin and trade cash secured (make sure you always have 100% of cash for a potential assignment). This will in my opinion limit your ability to use the full extent of you cash power. But it is safe.
2) Use margin and follow below rules to stay safe.
But my biggest rule about how much money you can use goes as follows:
Always use only 35% – 40% of your buying power (or account cash value) for trading. Never more. It is OK when the account temporarily exceeds 40%, but never open new trades when you are at the limit.
I further structure this rule and do not use all available limit. There are two reasons for it.
One reason is based on the market conditions. I look at the level of the market. If the current price of the entire market is at all time high or making new all time high, I use even less than 40% of available money (buying power). I use only 15% in this situation.
Why? When the market is at all time highs, the probability of it to fall or crash is high. The very next day it can fall hard in a violent sell off and it can drop 600 points in four days before you even blink an eye. We have been there right? Just look at August 2015 sell off.
But as the market continues falling off of the all time highs, the probability of it to recover is a lot bigger than a probability of further falling. Thus I employ more money.
Long story short, the more the current market price is off of all time highs the more money I use up to 40% limit. The closer the price of the market is to the all time highs the less money I use.
This will protect you from a damage. Even if you use only 40% of your total available cash and the stocks fall hard, you still may get dangerously to the maximum of your available money for trading and wiped out by margin calls.
The second reason for structuring this limit is that you need money for repairs. And this is also a reason why I recommend using this rule even in ROTH IRA or simple IRA or any other cash only account.
You will never be able to have all your trades 100% correct and winners. There will be trades which will go bust the very second you open them. And you need money to be able to roll those trades or repair them. If you are already maxed out, you will never be able to fix those trades and you will be forced to close them at a loss.
Here is a table I use to determine what percentage of my account I can deploy based on the market situation:
|Market off all-time high||Money invested|
|5% – 10%||30%|
|11% – 20%||35%|
|21% – 30%||40%|
|31% – 40%||45%|
|41% – 50%||50%|
I created a spreadsheet for myself which calculates the numbers mentioned above for me automatically. The spreadsheet is shown on the top of this page. It shows the all time high of the market, current price, how many percent it is off of the highs and based on that it selects how much money I can trade.
If the market is 4% off of the highs, then it is less than 5% and I can only trade 15% of my entire available buying power. And if I am over-invested then I do not open new trades until I get my account back to the limit level.
In the past I was breaking this rules blatantly and I also paid for it dearly. I try not to do it again.
The table at the very top can help you too. You can use the column indicating “off highs” and then on the line “Max cash to be traded” the second column indicates how many percent of your own money you can trade.