Implementing Money Management Techniques
Implementing sound money management encompasses many techniques and skills intertwined by the trader's judgment. All three of these ingredients must be in place before the trader is said to be using a money management program along with their trading. Failure to implement a good money management program will leave the trader subject to the deadly "risk-of-ruin" exposure leading eventually to a probable equity bust.
Whenever I hear of a trade making a huge killing in the market on a relatively small or average trading account, I know the trader was most likely not implementing sound money management. In cases such as this, the trader more than likely exposed themselves to obscene risk because of an abnormally high "Trade Size." In this case the trader or gambler may have gotten lucky leading to a profit windfall. If this trader continues trading in this manner, probabilities indicate that it is just a matter of time before huge losses dwarf the wins, and/or eventually lead to a probable equity bust or total loss.
Whenever I hear of a trader trading the same number of shares or contracts on every trade, I know that this trader is not calculating their maximum "Trade Size." If they where, then the "Trade Size" would change from time to time when trading.
In order to implement a money management program to help reduce your risk exposure, you must first believe that you need to implement this sort of program. Usually this belief comes after having a few large losses that cause enough psychological pain that you want and need to change. You need to understand how improper "Trade Size" actually will hurt your trading.
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 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 and not fall prey to the "risk-of-ruin" outcome?
When traders ask themselves that, they will then either adjust their "Trade Size" or tighten their stop-loss before entering the trade. In most situations, the best method it 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 good traders test their trading systems, they have a good idea of the probabilities of how many consecutive losses in a row can occur. Taking this information into account, allows the trader to further determine the appropriate risk percentage to take on each trade.
Let's talk about implementing sound money management in your trading formula so as to improve your trading and help control risk. The idea behind money management is that given enough time, even the best trading systems will only be right about 60% to 65% of the time. That means 40% of the time we will be wrong and have losing trades. For every 10 trades, we will lose an average of 4 times. Even trading systems or certain trading set ups with higher rates of returns nearing 80% usually fall back to a realistic 60% to 65% return when actually traded. The reason for this is that human beings trade trading systems. And when human beings get involved, the rates of returns on most trading systems are lowered. Why? Because humans make trading mistakes, and are subject from time to time to emotional trading errors. That is what the reality is and what research indicates with good quality trading systems traded by experienced traders.