Continuing on from my previous post on trading by Ray Barros, this post covers on the topic of money management. 

Ray Barros mentioned that 80-90% of newbies will show a loss in their first 12 months of trading. 3-6% even lose their entire trading capital. The single most important reason why this happens is unrealistic expectations.

Professional traders try to make money slowly. Amateurs try to make it quick. For example, making a 10-20% return in a year can be considered a pretty decent return. Some newbies expect to make that same kind of returns in a month. This leads them to take larger positions then they should be taking — often with disasterous results.

A proper money management system defines the risk (amount of capital) you risk per trade by helping you to determine the correct position sizing to take. The factors that affects it include your capital base, the volatility of the market and the expectency of returns.

The expectency can be calculated by taking:

Average $ win x win rate – average $ loss x loss rate

You cannot control your win rate, but you can control your entry and exit prices. These set prices help you to determine the risk you put into every trade, and the maximum reward you can get.

A good risk to reward ratio is crucial for getting consistent results from trading.

Depending on the time frame you are trading, the risk to reward ratio will be different.

The shorter the time frame, the lower the profit you can make on each trade, and the higher your win rate has to be. For example:

Type of trader : risk reward ratio : win rate required

• Scalper : 0.5-1 : 80%
• Day trader ; 1+ : 70%
• Position trader : 1.8-2.5 : 50%

Ray Barros shared with us two methods for determining the correct position sizing. The second method is more complicated and requires data from your trading records, so I will just talk about the first one here.

Decide on the risk you will take on each trade. Typically, this is about 2-5% of your trading capital. Using an example of $10,000 as trading capital and risk of 2%, this works out to be $200. 

Suppose then that I enter a trade at a price of $100. Based on technical indicators, I determine the take profit price to be $120 and the cut loss level to be $90.

This trade has a good risk reward ratio of 2. 

As the cut loss level leads to a loss of $10, the maximum number of contracts that can be taken is $200/10 = 20 contracts

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On the first day of the ATIC, I attended mainly the free sessions. One of them that I attended is “Money Management” conducted by Stuart McPhee, a professional trader from Australia and editor of “The Traders Journal”.

Money management is one of the three pillars to trading success, the other two being your psychology and the system you use. If you were to ask professional traders what makes a successful trader, most of them will give a higher weightage to money management than to the system itself. Stuart McPhee has this weightage:

• Psychology – 60%
• Money management – 30%
• System – 10%

Most novice traders start out by looking for that “perfect system” or “Holy Grail”, thinking that having one will ensure their trading success. Based on the above numbers, that would be a huge mistake.

Other than the fact that such a perfect system doesn’t exist, not having the correct psychology and money management is also guaranteed to ruin you in the long run. Here’s why.

Let’s talk about psychology first. Imagine for a moment that you have a trading system that gives you 99% accuracy. Without the correct psychology, you will find yourself giving manual over-rides to what the system tells you to do. Doing what you were not supposed to do and failing to act when you were supposed to. That is what we term as impulse trading. Trading on emotion is one sure way to financial disaster.

How many times have you traded based on emotion and what were the results of those trades? Trading based on hope rather than on your plan. I’m often guilty of this myself too.

For an emotional trader, it is likely that he will have more wins than losses. However, that one or two losses usually amounts to more than all his winnings.

The other pillar, money management, refers to the size of the bet you take. The maximum amount you can lose on any trade in reference to your trading capital. Here are two extreme examples:

Trader A has a system that gives him 50% accuracy. He has a cut-loss level such that he will lose a maximum amount of 2% of his capital on every trade. To be wiped out of his entire capital, he will need to be wrong 50 times in a row (actually more if his 2% is based on current capital). This is an event that has a 0.0000000000000888% chance of happening.

Trader B has a system that gives him 99% accuracy. He commits 100% of his capital to every trade. Sure, you will see incredible growth in his portfolio initially but that 1% error will come sooner or later. And when that happens, he is left with nothing.

Remember the primary aim of trading is to preserve our capital! That is why money management is so fundamental to our trading success.

Risk is not avoidable and it is important to control it by having capital perservation techniques. This is done by having stop loss levels and more importantly, adhering to them.

A poor entry level can often be saved by a good exit and correct position sizing.

Stop loss levels can be based on one of three things: a technical stop, volatility stop or a retracement stop.

A simple position sizing method is to simply take the maximum amount you can lose on each trade (a good number is 2% of your capital), and divide it by your distance to the initial stop. That is the number of contracts or lots you can make.

Another guideline is not to have more than 20% of your portfolio into any one single trade.

Here are some additional rules by Stuart McPhee for successful trading:

• Follow the trend.
• Cut your losses.
• Let your profits run.
• Don’t overtrade.
• Never react to a tip.
• Always trade liquid stocks.
• Keep your position small.
• Don’t buy something because it is cheap.