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Wednesday, 13 May 2009

Money Management

by Bennett McDowell

Money management in trading involves specialized techniques combined with your own personal judgment. Failure to adhere to a sound money management program can leave you subject to a deadly “Risk-Of-Ruin” exposure and most probable equity bust.

With this in mind, here are a few essential money management techniques that can make a big difference for your bottom line:

1.Always Use Stops
2.Use A Proven And Tested Methodology For Calculating Stops Rather Than An Arbitrary Figure
3.Use A Proven And Tested Trading System
4.Pay Close Attention To Your “Trade Size” For Each Trade And Be Sure That You Take Into Consideration The “2% Risk Rules”
5.Never Exceed A 2% Risk (Of Your Trading Account Size) On Any Given Trade
6.Never Trade More Than A 2% Risk (Of Your Trading Account Size) In Any Given Sector
7.Never Exceed A 6% Risk (Of Your Trading Account Size) Over-All At Any Given Time
8.Always Trade With “Risk Capital” (Money You Can Afford To Lose)
9.Never Trade With Borrowed Money
10. Use “Scaling” Out Of Positions To Boost Your Percentages
11. In Most Cases, Be Sure Your Trading Account Size Is Not Greater Than 10% Of Your Total Net Worth
12. Develop “The Trader’s Mindset”

When you hear of someone making a huge killing in the market on a relatively small or average trading account, you can bet the trader was not using sound money management.

They more than likely exposed their trading account to obscene risk due to an abnormally large “Trade Size.” The trader (or gambler) may have just gotten lucky and experienced a profit windfall. By trading in this manner, it’s just a matter of time before huge losses dwarf the wins, and the trader (or gambler) is devastated emotionally and financially.

Calculating Proper “Trade Size”

If you are trading the exact same number of shares or contracts on every trade, then you may not be calculating the proper “Trade Size” for your own personal risk tolerance. “Trade Size” can vary from trade to trade because your entries, stops, and account size are constantly changing variables.
In order to implement a money management program to help reduce your risk exposure, the first step is for you to fully believe that you need this sort of program. Usually this belief comes from a few large losses that have caused the kind of psychological pain that makes you want to change. This kind of experience can enable you to see how improper “Trade Size” and lack of discipline can sabotage your trading results.

Novice traders tend to focus on the trade outcome as only winning and therefore do not think about risk. Professional traders focus on the risk and take the trade based on their proven trading system indicating a favorable outcome. Thus, the psychology behind “Trade Size” begins when you believe and acknowledge that each trade’s outcome is unknown when entering the trade. Believing this makes you ask yourself, “…how much can I afford to lose on this trade?”

Once you’ve answered this question (based on your money management rules), you’ll either want to adjust your “Trade Size” or tighten your stop-loss before entering the trade. In most situations, the best method is to adjust your “Trade Size” and set your stop-loss based on market dynamics.

During “Draw-Down” periods, risk control becomes very important and since experienced traders test their trading systems, they have an idea of how many consecutive losses in a row can occur. Taking this information into account, allows you to further determine the appropriate risk percentage to allow for each trade.

Not Every Trade Will Be A Winner

Given enough time, even the best trading systems will only be right about 60% of the time. That means 40% of the time you will be wrong and have losing trades. For every 10 trades, you will lose an average of 4 times. Even trading systems or certain trading set ups with higher rates of return nearing 80% usually “fall-back” to a realistic 60% return when actually traded.

The reason for this “fall-back” is that human beings trade trading systems. And when humans get involved, the rates of return on most systems are lowered. Why? Because the very nature of being human is that we make mistakes, and are to emotional trading errors. That’s what the reality is and what research indicates.

So, if you’re losing 40% of the time then you need to control risk! This can be done through implementing stops and controlling “Trade Size”. We never really know which trades will be successful. As a result, we have to control risk on every trade regardless of how profitable we think the trade will be. If our winning trades are higher than our losing trades, we can do very well with a 60% trading system win to loss ratio. In fact with effective risk control, we can sustain multiple losses without devastation to our trading account and our emotions.

Some folks can start and end their trading careers in just one month! By not controlling risk and by using improper “Trade Size” a trader can go broke in no time. It usually happens like this; they begin trading, get five losses in a row, don’t use proper “Trade Size” and don’t cut their losses soon enough. After five substantial losses in a row, their trading capital is now too low to continue trading. It can happen that quickly!

“The Trader’s Mindset”

Equally important as controlling risk is having confidence in your trading system. You must understand that even with a tested and profitable system, it is possible to have a losing streak of five losses in a row. This is called “Draw-Down”. Knowing this eventuality can prepare and encourage you to control risk and not abandon your trading system when “Draw-Down” occurs.

This confidence is an important psychological ingredient in “The Trader’s Mindset”, which is the mindset you need to develop to be consistently profitable. You are striving for a balanced growth in your trading equity curve over time. When you see that steady balanced growth then you’ll know you’ve developed “The Trader’s Mindset”.

The “2% Per Trade Risk Rule”

The “2% Per Trade Risk Rule” will keep you out of trouble provided your trading system can produce 55% or above win to loss ratio with an average win of at least 1.6 to 1.0 meaning wins are 60% larger than losses. So, for every dollar you lose when you have a losing trade, your winning trades produce a dollar and sixty cents.

Assuming the above, we can then proceed to calculate risk. The “2% Per Trade Risk Rule” is calculated by knowing your trade entry price and your initial stop loss exit price. The difference between the two gives you a “Dollar & Cents” number that when multiplied by your “Trade Size” (shares or contracts) will give you the dollar loss if you are stopped out.

That “Dollar & Cents” loss must be no larger than two percent of the equity in your trading account. It has nothing to do with leverage. In fact, you can use leverage and still stay within a two percent risk of equity in your trading account. Remember the two percent risk must include commissions and if possible slippage, if you can determine that.

If you do not add-on to a current position, but your stop moves up along with your trade, then you are locking in profits. When you lock in profits with a new trailing stop, your risk on this profitable trade is no longer 2%. Thus, you may now place additional trades. So, multiple positions can be possible.

The “2% Per Sector Risk Rule”

Since the stock market is comprised of many different sectors, it is important that you use the “2% Per Sector Risk Rule”. This rule allows you to risk 2% per sector up to a total risk of 6% maintaining proper diversification in your trading account.

For example, the stock MSFT (which is Microsoft) is a technology company in the technology sector. If you want to take another trade while you are in a Microsoft trade, you will want to select a different sector of the market, such as the chemical sector or the banking sector. This same rule applies to Options and Futures. In Futures, trade a different commodity. Using this rule you will be automatically diversified and won’t be likely to take a huge hit if one sector of the market collapses.

Also note that if your risk on a given trade in one sector is only one percent, you may take additional trades in that sector until you reach a total of two percent.

The “6% Over All Risk Rule”

You should not exceed six percent over-all between all sectors. In other words, the most or total trading account portfolio risk you should have at any given time should not exceed six percent. Using this technique will keep your risk in proportion to your trading account size at all times.

“Risk Capital” – Funding Your Trading Account

It is alarming that many traders use either borrowed money or money they really cannot afford to lose. This will set you up for failure because you are subject to the market’s manipulation which exploits your emotional need for a positive outcome on every trade.

In simpler terms, you could be nervous about losing. Therefore each stop out would create more anxiety to a point where you may not emotionally be able to exit a trade and take a loss. Instead you are hoping the trade will come back. It takes both responsibility and discipline to accept a trading loss and get out when your stop tells you to.

If you do not currently have sufficient risk capital to trade, begin “Paper Trading” to improve your skills while you are saving enough risk capital to begin trading with real money. This way when you are ready to trade with real money you will have practiced your trading skills and will have a greater opportunity to be consistently profitable.

“Scaling” Out Of Trades

“Scaling” out of trades can be incorporated into your money management game plan since it is a component of risk control. The psychology behind “Scaling” out is to reduce stress by quickly locking in a profit, which should also help you stay in trends longer with any remaining positions.

This is a great technique that can convert some losing trades into profitable ones, reduce stress, and increase your bottom line! I’m a big advocate of reducing stress while you’re in a trade. Then you’ll be able to focus on the trade and not be subject to emotions such as fear and greed. Properly “Scaling” out of positions is a win-win technique by making you more profitable and by reducing the stress.

In order to “Scale” out of trades your initial “Trade Size” must be large enough so you can reap the benefits of “Scaling.” The technique is applicable for both long and short positions, and for all types of markets like Futures, Stocks, Indexes, Options, etc. The initial position must be large enough to enable you to cover your profitable trade in increments without incurring additional risk from a large opening position. Remember, we want less stress, not more!

Your initial “Trade Size” should follow the “2% Per Trade Risk Rule”. The key is to initiate a large enough “Trade Size” while not risking more than 2% on entering the trade.

There are two ways to do this. One way is to find a market that you can initiate a large enough “Trade Size” with your current trading account based on a 2% risk if this initial position is stopped out. The other way, is to add additional trading capital to your trading account that will allow for a larger position because 2% of a larger account allows for a larger “Trade Size.”

There is even another way, and that is to use the leverage of Options, but you must be familiar with Options, their “Time Value” decay, delta, etc. Using Options would be considered a specialty or advanced technique, and if you are not familiar with them, use caution since this method could lead to increasing your stress!

If you’re stopped out before having a chance to “Scale” out, your loss would only be 2% which is acceptable from a “Risk-Of-Ruin” stand point. If on the other hand your trade is profitable you can cover part of your position and liquidate enough contracts so that if you are still stopped out, you make a small profit! If the trade becomes even more profitable, then you may want to liquate additional contracts to lock in more profit.

By trading only one or two contracts you can’t “Scale” out of positions well. This clearly illustrates how larger trading accounts have an advantage over smaller ones! Also, some markets are more expensive than others, so the cost of a trade will determine “Trade Size.”

In choosing a market, liquidity is crucial. Make sure there is sufficient market liquidity to execute “Scaling” out of positions in a meaningful way. Poor fills due to poor liquidity can adversely affect this “Scaling” out technique.

Actual Money Management Examples

Example A: The “2% Risk Rule

Trading Account Size: $ 25,000
2% of $ 25,000 (Trading Account Size) = $ 500
(Assuming no slippage in this example)

Thus on any given trade you should risk no more than $500 which includes commission and slippage.

Example B: Using The “2% Per Trade Risk Rule” In The Market Place

Trading Account Size: $25,000
2% Risk Allowance: $500
MSFT Current Value: $60.00 Per Share
MSFT Initial Stop: $58.50 Per Share
Difference Between Entry & Stop: $1.50
Commission: $ 80.00 Round Trip
Proper “Trade Size”: 280 Shares

Your trading system says to go long now at $ 60.00 per share. Your initial stop loss is at $ 58.50 and the difference between your entry at $ 60.00 and your initial stop loss at $58.50 is $ 1.50 per share.

How many shares (“Trade Size”) can you buy when your risk is $ 1.50 per share and your two percent account risk is $ 500.00? The answer is: $ 500.00 minus $ 80.00 (commissions) = $ 420.00. Then, $ 420.00 divided by $ 1.50 (difference between entry and stop amount) = 280 shares.

Do not buy more than 280 shares of the stock MSFT to maintain proper risk control and obey the “2% Per Trade Risk Rule.” If you trade Futures contracts or Options contracts, calculate your “Trade Size” the same way. Note that your “Trade Size” may be capped by the margin allowances for Futures traders and for Stock traders.

This E-mini intraday 1 minute chart illustrates how you can “Scale” out of a position but still remain in the trend.

Money Management Conclusion

It is important to realize that you must be aware of the risks in trading the financial markets and live in full awareness. Let your positive beliefs lead you to take the action necessary to succeed.

For traders to blindly enter the markets and trade simply because they are thinking positive thoughts is to ignore the full spectrum of what is possible. On the other hand, to live in the fear of only losing will cause you to trade the financial markets with fear, anxiety, negativity and aggression which are equally destructive. Instead, acknowledge both sides of the coin, the good and the bad. React to market activity with full-awareness and pay close attention towards risk control then you will create a positive reality with a feeling of abundance and good will.

By acknowledging the good and the bad (the reality) and by fine tuning your money management system you are on your way to greater prosperity.

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