Money Management

Crucial but often overlooked, money management practices can mean the difference between winning and losing in the markets.

Plenty of books, manuals, and software packages will help you form and opinion of a market, but not many will tell you how to trade once you have decided to get long or short. The goal of money management is to increase the odds of high quality trades. And as we’ll see, leaving the money management variable out of your trading equation can lead to ruin, even if you’re correct about the market direction.

In a broad sense, money management can encompass those elements of trading outside the initial decision to get long or short in a given market or markets – that is, how many positions to put on, when to get out, where to place protective stops. More specifically, it refers to the strategic allocation of capital to limit risk and optimize trading performance in the long run. Allocation of capital can refer to how much money to put into any one market or how much money to risk on any one trade. These decision directly affect how many positions to put on and where to place stop orders.

Given the negative odds inherent in trading (a successful trader can expect to lose money on 60% of his trades), how do you go about maximizing the profit potential of the few winning trades you can expect to have? The answers vary with the disposition and trading style of the individual trader. There exist, however, basic concepts that can be successfully adapted and modified to individual needs, and when the followed in spirit, can boost the promise of long-term trading profits and take some of the stress and uncertainty out of trading.

-Establish A Goal- Having a clear idea of what you want to accomplish by trading, whether it is a short-term profit on a single trade or the desire for a long-term trading career, can go a long way toward building successful trading habits. Regardless of whether or not the goals are set on a per trade, daily or long-term basis, establishing from the outset basic levels of acceptable risk and financial reward will help curtail avoidable risk and extreme losses. Also, determine a specific time frame in which to trade: Will a position have to be liquidated by a certain time for tax purposes or for same other reason?

-Diversification- Just as in the stock market, a portfolio of different instruments can be one of the best hedges against several and unsustainable losses; a loss in one market will hopefully be offset by gains in others. Traders must take caution, though, to truly diversify their portfolios with contracts that are price independent. Spreading your trading among three or four different interest rate contracts that move in a similar fashion is not a good example of diversification, because a loss in one contract is likely to be mirrored by losses in the others. But over-diversification is dangerous, too. A trader can spread his money over too many markets, and not have enough capital in any one of them to weather even small adverse price swings.

A good rule of thumb is to stick with what you are comfortable; do not venture blindly into unknown markets just for the sake of diversification. A balance must be stuck between available resources and a manageable trading scenario. Capital constraints will, of course limit the choices traders can make, forcing those with smaller trading accounts to bypass or minimize diversification.

Crucial but often overlooked, money management practices can mean the difference between winning and losing in the markets.

-Amount Of Money To Risk- It’s difficult to come up with hard and fast money to risk on different markets and trades. For our purpose, though, it’s best to think conservatively. Although some studies suggest initially allocating equity in broad terms of original margin (40% to 50% of total equity committed to the markets at a given time in the form of original margin, 15% to a particular market, 5% to a single trade, etc.), many traders consider these percentages too high, and do not consider the market to be a accurate measure of risk or a sound basis on which to allocate funds, because a trader can always, technically, lose more than the margin amount. These traders find it more beneficial to think in terms of the actual money amount they are willing to lose on any particular trade or trades, determined by their stop level or through some other calculation.

Although in specific circumstances professional traders may actually risk comparable or even greater percentages of total equity than those listed previously, on average they risk much less-perhaps 12% to 20% of total capital at a time, and 2% – 4% per trade. Depending on the size of your trading account, these levels might seem overly strict, but again, the idea is to conserve money for the long haul.

In developing your trading goal, determine how much you could accept losing on a trade, both financially and psychologically. Based on total capital and the number of markets in which you are active, allocate your equity proportionally between individual trade, market group and total trading activity levels.

These guidelines protect you from dangers of extreme leverage in the futures markets. Though it may seen attractive to have the change to make big money on a small initial investment, the risk of loss is just as great.

-Determining Reward/Risk Ratios- Another common rule in trading is never to put on a position unless your possible profits outweigh your possible losses by a ratio of 3 to 1, or at the very least 2 to 1. So, if a particular trade has the potential of losing $100, the profit potential should be at least $200 to $300. This is not a bad rule, but like so many aspects of trading, it is somewhat intangible. Once you have formed an opinion of a market, determined your entry point and calculated the maximum amounts you could win or lose on a trade, you still are left with the uncertainty of the probability of your trade winning or losing, and unfortunately there is not secret formula for removing this uncertainty.

Some traders don’t consider probabilities valid at all. The most any trader can do is perform his or her best analysis of the market, and, along with experience and intuition, come up with some rough idea of the probability of success for a given trade. This probability can then be weighed against the reward / risk ratio in selecting trades. For example, would it be better to put on a trade where the reward / risk ratio is four to one and the probability of success is 30%, or would it be advisable to put on a trade where the reward / risk ratio is only two to one but the probability of success is 75%? Using this rule, you’ll be ahead of the game by directing resources to the trades with the greatest chance of success.

Crucial but often overlooked, money management practices can mean the difference between winning and losing in the market.

-Placing Stop Order- It’s helpful to think of these by their more formal name, stop-loss orders, because that is what they are designed to do – stop the loss of money. Stop orders are offsetting orders placed away from the market to liquidate losing positions before they become unsustainable.

Placing stop orders is more of an art than a science, but adhering to money management rules can optimize their effectiveness. Stops can be placed using a number of different approaches; by determining the exact dollar amount a trader wishes to risk on a single trade; as a percentage of total equity; or by applying technical indicators.

Realistically, methods may overlap, and you’ll have a certain amount of leeway in deciding where to put a stop, but always be wary of straying too far from the basic asset allocation parameters established earlier.

For example, if a trader is long one S&P 500 future at 450.00, a based on his total equity he has a $2,500 to risk on the position, he might place a sell stop at 445.00, which would take him out of the market with a $2,500 loss ($500 per full index point, per contract). Buss after consulting his charts, he discovers strong support at the 444.55, a level he believes if broken will trigger a major break. If this level is not broken, the trader believes, that rally will continue. So he might consider putting a stop at 444.55 to avoid being stopped out prematurely. Although he’s risking an extra $225, he’s staying close to his money allocation percentages and modifying his system to take advantage of additional market information.

Of course, the size of a position will affect the placement of stops. The larger the position, the loser the stop has to be to keep the loss within the established risk level. Also consider market volatility. You run a greater risk of getting stopped out in choppy, “noisy” markets, depending on how far away stops are placed. This can cause unwanted liquidation when the market is actually moving your direction.

Now suppose our hypothetical trader, who started with $50,000, is now looking at a $10,000 gain (which happened to be his goal for this trade) on a long position. What should he do? That depends entirely on his trading goals. He can take the $10,000 profit and, assuming he leaves the money in his trading account, turn to other trading opportunities. If he desires, he can increase the size of his trades proportionally to his increase in trading equity. This would give him the potential to earn greater profits, with the accompanying risk of greater losses.

He also could choose to keep the size of his trades identical to what they were before he made his initial profit, thus minimizing his risk (as he would be committing a smaller percentage of his total equity to his trades) but at the same time bypassing the chance for larger profits. If his winning positions had consisted of more than one contract and he believed the market was still in an uptrend, he could opt to take his profits immediately on some of the trades, while leaving the other positions open to gain even more. He then could limit his risk on these remaining trades by entering a stop order at a level that would keep him within his determined level of risk, as well as protect his profits. He does run the risk of giving back some of his money if he is stopped out, but counters that with the potential for even larger gains if the market continues in his direction.

Good money management practices dictate stop orders be placed at levels that minimize loss; they should never be moved farther away form the original position. You should accept small losses, understanding that preservation of capital will in the long run keep you in the market long enough to profit from the wining trades that make up for the losers.

Trading in the real world almost never seems to go as smoothly as it does on paper, mainly because paper trading typically never figures in such real world factors as commission, fees and slippage. “Slippage” refers to unanticipated loss of equity does to poor fills (especially on stops) that can result from extreme market conditions or human error. Factoring these elements into your overall money management program can help create a more realistic trading scenario, and reduce stress and disappointment when gains do not seem to be as large as they should be.

-One Final Note- Do your money management homework before you start trading. This helps you decide what to trade and how to trade it. On paper, money management sounds so obvious and based on common sense that its significantly overlooked. The challenge is to apply its principles in practice. Without money management, even the most astute market prognosticator may find himself caught in a downward trading spiral, right on the trend, but wrong on the money.