THE MONEY MANAGEMENT BASICS
Though there are several aspects to money management, and Ill run through them briefly below, just keep in mind that the overall goal is to keep as much of your money as possible. This can be done by keeping your risk and losses as minimal as can be, so that you will always have another trade to make. If you play poker you know the expression a chip and a chair. It means as long as you have even a little bit of money you have a chance; if you are wiped clean however, you cant do a thing. Getting wiped out is not fun and if you are always maxed out there is always a chance it could happen to you.
Before I go into what is needed in a money management plan, I want to emphasize that the best risk management will not help much unless you are trading a system with positive expectancy. That is a proven trading strategy. If you have a strategy that is not going to make you money over the long run, then money management will keep you in the game longer, but you stand little chance of making money.
How Much to Risk
In General First of all, you need to determine how much you can afford to risk in general. This is money you have dedicated just to trading and is your total risk capital. You may have $400,000 available to you after selling your house. The question you need to ask yourself is how much do you want to trade with and ultimately risk$10,000, $50,000, $100,000, or the whole $400,000? Whatever you decide on you must know that there is a chance that money will be lost if you are trading actively. If you are investing in stocks, your risk of losing it all is small compared to trading futures, but it is still there. If you cannot stomach losing X amount, lower your total risk capital. Some people are comfortable putting all their money into one stock and holding it for a while. While others may only want to trade with $10,000 for kicks.
At Any Given Time Once youve established your total risk capital, next you have to find a percent of your total capital that you are willing to risk at any given moment in time. This will be the at-risk capital. If you are trading with $100,000, you should not have it all at risk at once, and Im not talking about just in one position but even spread out over all your positions. You are better off trading a lesser amount, so that you always have something to fall back on. I think a good amount is 50 percent of total risk capital, but this could vary based on the correlation of the positions or whatever you think is best for you. By keeping half your money safe, youll always ensure that youll be around for another trade, and another and another. The problem comes that when losing, people may not cut back on their positions as they are supposed to. Instead, they may even increase their risk in hopes of recouping the losses. So, if they lose half of their total money, they may risk the whole other 50 percent on the next trade trying to make it back. This is not a great management strategy and should be dealt with in your trading plan. The reason this is not a good strategy is that if you start with a $100,000 and lose half, you have lost 50 percent of your total, but if you take the remaining 50 percent and try to get it back to $100,000 on one trade, well then you need to make a 100 percent return to get back to even. Returns of 100 percent are not easily done on one trade. Plus you should never ever max out your capital at any given time; always leave something to fight your way back with. Try not to put yourself in a situation where you have lost half of your money in the first place, but if you do, the proper thing to do is to forget how much you lost and only risk half of your remaining capital.
If you choose 50 percent of your total risk capital as the amount you are comfortable risking, take the other 50 percent and earn some interest on it. Next you should take the 50 percent you are risking and break it down further. If you risk all of the 50 percent all at once, you may just lose it, so you dont want to do that. What you should do is break that up into increments that you will have at risk at once. This could be 20 percent or 33 percent or whatever you choose of the at-risk capital, and well call it the at-risk-at-one-time capital. If you are a new trader who doesnt have a
clue what he is doing, you should maybe only risk 10 percent of your total risk capital at once. You are most likely going to lose it anyway, so this will force you to trade small as you learn. When youve lost that 10 percent, then risk another 10 percent, and so on. Hopefully each time it takes longer to lose it. Then as you get better, you can start increasing your total amount risked. By doing it this way you will not have a huge uphill battle.
On Any Given Trade After you have established how much you can risk at any given time, next you have to figure out how much you are willing to risk per trade. Say you decided that $20,000 would be your maximum exposure at any given time (This is out of a $100,000 total risk capital.) An acceptable amount of your capital to risk per trade is 2 percent to 10 percent with 2 percent to 5 percent being the best ratio. The smaller your trading account, the bigger the ratio will be, but its always best to make it as small as possible. For the sake of this example well assume you are willing to risk 5 percent of your risk capital on any given trade ($1,000). You may be thinking thats not a lot of money, and its not, but its the proper amount you should risk with that size account. Most people get screwed because they risk much more than they should.
Risking $1,000 per trade also means if you really want to, you can put on 20 positions at once, but we saw in the last chapter that this isnt a great idea. This $1,000 doesnt mean you can only trade $1,000 worth of one stock at once. It means you are risking this amount, and this is where your homework and technical analysis come into play. So if you want to trade a stock thats trading at $50 a share, you have to first determine the risk of the trade and the amount you could lose per share. If you are confident you will not lose more than $3 per share you can then trade 300 shares. I know this comes out to $15,000 and some people will be confused thinking thats 75 percent of your total $20,000 leaving you little else to trade with, but depending on the account you have you may have a 4 to 1 day-trading margin and a 2 to 1 overnight margin. This means you only need to put up as little as $4,000 for the trade and you may think you can make five other trades like this. But the $20,000 only represents how much you are risking at any given time; you actually have $50,000 at risk in your account. So you have plenty of room to play with. As long as you can keep to your stop losses and control the risk to the $1,000 you established, its okay to use your total at-risk capital to make a trade. For example, assuming you have no margin at all and you see a great opportunity in a $50 stock where you are risking 80 cents a share, its okay to buy 1,000 shares and tie up all your capital. However, you must adhere to a stop, and you have to remember that something dramatic may happen that can cost you a lot more money, such as a drug company getting a major recall.
If you are trading commodities, the margins can really screw your plans up as they give you too much leverage. They allow you to control a huge position with little money. For example, the margin on an E-mini contract is $4,000 and only $2,000 to day-trade it. If the S&P moves 10 points in a day one contract will have a $500 move, which is a.12.5 percent move versus your outlay. To compare, look at a $50 stock like Merrill Lynch that will move about 2 points in a day the S&P moves 10 points. Assuming you are using 50 percent margin, you can trade up to $8,000 worth of the stock (to correlate with the amount you need to trade an E-mini) this means you can trade 160 shares. If you do get that $2 move, thats worth $320, this in turns equates to 8 percent of the $4,000 you needed to make the trade. So the bottom line is that you risk 50 percent more with futures when trading the same amount of money and using basically the same trading idea. And it is because of this added leverage/risk that you really need to be careful. Dont think because you have the margin available, you need to use it all. If you are overmargined and something bad happens it can destroy you. Always leave yourself a cushion for a worst-case scenario.
There was a lot to think about in last few pages, you may want to reread them. If it didnt all make perfect sense, the main point of the section is about knowing how much money you will be risking per trade. Its important and it is the foundation of forming a solid risk plan, so make sure it is clear.
How Many Positions at Once
Another aspect of a money management plan is to decide how many positions you can trade at once. This is not as easy as just saying Ill trade a max of five positions. There are a lot of different scenarios you could take into account that will influence how much you will have on at any one time. You can, for instance, base it on a ratio of how much available money you have versus the risk levels you assumed. For example, if you already have four positions on but are only risking 25 percent of your at-risk-at-one-time capital, you may give yourself a clause that says you can trade up to seven positions as long as you are under 40 percent of your at-risk-at-one-time capital. But if you are already at 40 percent of your equity then you can only trade five positions. This way of doing it is a bit complicated and you will never have concrete rules. But it allows you to expand a bit if you are not risking as much as you would normally risk.
You can also have different limits depending on whether you are daytrading or holding trades overnight. For example, you may limit your daytrading positions to 4 at any one time, but you may allow yourself to take 10 overnight. Its easier to monitor overnight trades as you can do all your homework once the market is closed and then have all your plans, stops, and targets in place for the next day or whenever it is you get out of them. Now this brings you to another option, which is how many positions you can day-trade if you have positions you are taking overnight. If the overnight trades are long term you may want to give yourself more freedom during the day. However, if you plan to actively monitor and trade these the next day, then you may want to limit the number of new trades you put on and may not be able to trade anything new until you get out of at least some of the current positions.
And finally, I think, you will want to consider how you will handle trading in similar markets. Say you allow yourself to trade 20 stocks at once. The risk is a lot different if you are trading 20 semiconductor stocks, as opposed to four semis, three oil drillers, two banks stocks, a retailer, two drug companies, and so on. In the first scenario, you are exposing yourself way too much in one sector and its almost like risking all your money in one stock. In the latter scenario you are spreading out your risk and are less likely to get hurt by a special event. So you should set limits as to how many positions or how much capital you are willing to risk in one sector.
Here is a simple idea that can really save you a lot of money. You should have cutoff points, where you acknowledge you are not having a good day or stretch of days. Instead of continuing trading, you should throw in the towel, admit you are whipped, and more importantly limit a potentially disastrous situation while giving yourself time to regroup. You cannot lose all your money if you cut yourself off, so as you make a money management and trading plan give yourself limits where you will take a break from trading. Even if it is not a reasonable limit, at the very least you should have one that will prevent you from getting wiped out completely. When I first started out trading, I lost $12,000 in a day with a $25,000 account, which is not very smart. Ive also blown $70,000 in a weeks trading, with a $50,000 account, with the help of commodity margins. That one was really not smart. If I had had reasonable loss limits, like $2,000 a day or $10,000 in a week, and developed my game plan around those limits, I probably would have fared much better, though then I wouldnt have had enough material to write a book or two.
I know its hard to cut yourself off when losing because first your ego doesnt want to admit you are wrong and second you always believe that you will turn it around on the next trade. And yes it does happen where the market turns around and makes a sharp move in the other direction and turns a huge losing day into a massive winning day, but these days tend to happen less than the days where your losing escalates beyond control. In the long run, you will be better off learning to walk away and recouping your senses.
The most straightforward method to come up with a cutoff level is to just use a fixed dollar amount. And once you hit it, you need to cut yourself off. It could be $2,000 a day or $10,000 a week or whatever you like. Here are some methods for coming up with those levels.
By Percent of Capital The first one is a straight percentage of your capital. The more capital you have, the lower this percentage will probably be, but keep in mind that the less capital you have the more you will put yourself at risk. If a professional trader cuts himself off with a 2 percent loss that could mean $2 million to him. If you give yourself a 2 percent cutoff, it may mean $200 is the proper amount you should consider losing before walking away. However, this means you may not be able to trade close to anything you want to trade and its also hard for people to keep to such a small loss. So small traders will end up having to raise up their limits to between 10 percent and 20 percent, which puts them more at risk in general compared with deep-pocketed traders. The one little hassle with this method is you have to calculate the level every day as it changes with your total capital.
By Dollar Value Based off a Percent Based off a Range You may also set a dollar value that is based off of a percent, which is based on a range of your trading capital. Let me clear that up a bit. You can say,I will make my cutoff point 5 percent of my capital and set it as a fixed dollar amount for every $5,000 in equity. To clear that up further, if you have between $25,000 and $30,000, you will risk $600 in a day. I set the range at the higher end of the spread because I assumed I started trading with $30,000 and use 5 percent of that ($600) until I drop below $25,000. Once you drop below $25,000 you then drop your maximum loss to $500. This is a little easier than calculating it every day and still has the same basic effect.
By a Ratio of a Good Day You can also set your limit by first setting what you believe to be the average of what your best good days could be. Exclude any exceptional days as they will skew your results. Just take an average of your better-than-normal good daysmaybe an average of your best 10 percent of days. Then come up with a ratio that gives you a number you are willing to lose based on that. I think a 3:1 win:loss ratio is acceptable. So if after substantial back testing or a years worth of results you believe that a reasonable average of your best days is $6,000, then set your maximum loss level to $2,000. Make sure you recalculate this amount as your equity changes.
Dont Give Away Your Profits
Another cutoff you may want to have is one where instead of just protecting yourself from a bad day, you protect your profits. If you start off with some good trades or had trades overnight that really opened in your favor and you are up a good amount, you do not want to give it back. Its your money, it doesnt matter if its paper money and you havent realized it or if you had it to start with. Hold on to it, and preserve your precious capital (a term I used a lot in High Probability Trading). In the long run, every dollar counts when you figure out how much money you made or lost at the end of the year. Dont get too cocky and think its okay to give up a bit or take chances and make marginal trades just because you are doing okay. Each trading decision you make should be made regardless of your previous trades and not on how well or poorly you have done.
To get back to the topic, if your maximum cutoff point for a day is $2,000, then you may want to have that as the most you are willing to give back during a good day. You could set this cutoff point anyway you want, just have one in your money management plan, because the worst feeling in trading are the days you were up $4,000 at lunch and walked away up $34 at the end of the day. I find those days more demoralizing than the days where I actual lose $5,000 in a steady manner. The emotional high to low swing of these days can take a toll on you.
A Longer Break
So far Ive only mentioned having intraday cutoffs, but you also should have a point where you acknowledge something just hasnt been working recently and you take time to reevaluate. For example, if at any given point you are down more than 20 percent in your account, you will make a provision to get out of all your positions and take a trading break until you examine what went wrong. You can also do this by saying if you have 7 consecutive losing days or 10 consecutive losing trades you will cut yourself off as well. The goal of this is to evaluate whether you have a fundamental flaw in your trading plan that needs to be fixed before you lose even more. It serves another purpose as well and that is that it gives you time to regroup. After a losing streak people do foolish things because their minds are cluttered with negative thoughts. By taking a break, you can start from scratch and hopefully avoid the mistakes people make when they are trying to catch up.
Position size is another factor you will have in your money management plan, which will tell you just how many contracts/shares of any given market you can trade at once.
Position size can be derived in several ways. The simple way at the beginning is to always trade the same 100 shares of a stock and one contract of a commodity. This is a good way to start, but ultimately position size should be based more on the risk of the trade and not a fixed amount. A better way is to figure out how much at worst you are willing to lose per trade and divide that by the risk of the trade. If you established that you will risk up to $2,000 on any given trade, and you have a trade where the risk will be $400 per contract, then you can trade five contracts. This is pretty straightforward and not the most advanced method of position sizing.
One thing you can have in your trading plan is a list with a range of position size ranges that you are willing to trade per market or stock, something like what is shown in Table 15.1. One way you can determine these ranges is by margin requirements, or maybe by the average true range of the market.
After you have established your position size risk range, as you are preparing your trades every day and have to determine the risk involved with the trade, you could decide how many contracts in that zone you will trade. I dont recommend maxing it out; give yourself a cushion, because hey, if you are wrong, youll lose that whole amount. You may also want to leave room to later add to the trade if you deem it worthy.
Stops are a crucial part of successful trading as they are the best way to protect yourself from disaster. The problem many people have with stops is that they use them incorrectly. The bad way to use stops is to say, I can afford to lose $1,000 dollars total on these two contracts, and so Ill place my stop at $500 away because it will cut my loss off at $1,000. When randomly placed, a stop could be in the normal trading range of the trade and you can easily get stopped out on a normal move. So even though you had a good trade going on, it gets needlessly stopped out.
What people who do this usually do wrong is set their position size first and then set their stops based on how much they are willing to lose, with no regard to what the market is telling them. In reality it should be the other way around. You should determine, based on the market, where a stop should be and then figure out how much it would cost you if you got stopped out. Then you figure out how many shares you can comfortably trade.
Stops will become an important part of your trading decisions as you make and adjust your daily game plan. Stops will let you know in advance how much you will most likely lose. It helps when a loss doesnt come as a surprise; you are mentally able to deal with it better if you knew the worst beforehand. By being prepared for a loss, you will reduce the urge to stay in bad trades that you should have gotten out of. Looking to see where a stop should be properly placed, will tell you if you should get into a trade, how many contracts you can safely trade, and where to get out. They will limit your losses and protect your profits as well.
The Reward-to-Risk Ratio
One thing you should do is establish a reward-to-risk ratio below which you will not enter a trade. I talked about this in detail in Chapter 10 so I just want to refresh it in your mind now, as it is a crucial step in establishing your risk parameters. If you are making a proper money management plan you need to work on establishing a level that you find acceptable to make a trade at. At the very least you need to know what the risk is and what the potential gain is and make sure the reward is greater than the risk You should also take into account the chance of the trade working. Though I look for a 3:1 ratio as a minimum, I will make a trade at a 2:1 ratio if the setup is a particularly strong.
Changing Trading Size
Knowing when to increase and decrease your trading size will be another factor that should be considered in your money management plan. You should have predetermined rules to know when you will ramp up or scale down your trading, based on your account size or performance. Having this predetermined can save you from the potential disaster of increasing your size too much like my friend did in wheat or being too aggressive on a losing streak.
You want to know when its okay and proper to increase or decrease the amount you will trade/risk based on your account size. I prefer using the percentage based on a range of my trading capital method I discussed earlier in the chapter. Once you set that range, win or lose stick to it. Do not let winning and losing streaks, ego, fear, or stupidity cause you to change it.
Some people increase their position size as they are doing better on a trade, others increase it as they are losing hoping to make money back. Same with scaling back, some like to cut down their trades when winning and others do the opposite. The proper thing to do is add to winners and cut back on losers. Its easy to get caught up the wrong way if you let emotions control you, so its best if you have provisions for it in your trading plan.
There is another time you need to change trading size that has nothing to do with your account size and that is when the volatility changes. If 10 contracts were proper in a small range market and then it explodes, only 2 or 3 contracts may be proper to trade. This is about changing risks and should be addressed in a proper money management plan.