Money Management

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.

If we are losing 40% of the time then we need to control risk! This is done through implementing stops and controlling position size. We never really know which trades will be profitable. As a result, we have to control risk on every trade regardless of how sure 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 risk control, we can sustain multiple losses in a row without it devastating our trading account and our emotions.

Some traders 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 position size and don’t cut their losses soon enough. After five devastating losses in a row, they’re trading capital is now too low to continue trading. It can happen that quickly!

It is equally important that the trader is comfortable with their trading system and have the knowledge to know that it is possible and inevitable to have a losing streak of five losses in a row. This is called drawdown. Knowing this eventuality prepares the trader to control their risk and not abandon their chosen trading system when it occurs. It is another ingredient in "The Trader’s Mindset."

What we are striving for is a balanced growth in the trader’s equity curve over time.

Below is a list of the ingredients in devising a sound money management plan for your trading:

  1. Always use stops
  2. Determine your "Trade Size" based on your trading account equity, your stop loss price for every trade
  3. Never exceed a loss of 2% on any given trade
  4. Never trade more than 2% on any give sector
  5. Never exceed a total portfolio risk of 6%
  6. Always trade with risk capital, money you can afford to lose
  7. Never trade with borrowed money
  8. Don’t overtrade based on the time frame you have chosen to trade

"Trade Size" And The 2% Risk Rule

The two percent risk rule along with the six percent portfolio risk rule are shown to keep a trader out of trouble provided their 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 loses. 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 two percent risk is calculated by knowing your trade entry price and your initial stop loss exit price. The difference of the two gives you a number that when multiplied by your position size (shares or contracts) will give you your dollar loss if you are stopped out. That dollar loss must be no larger than two percent of the equity in your trading account. It has nothing to do with leverage, and in fact you can use leverage and still stay within a two percent risk of equity in your trading account.

Money Management Example

Calculating The Dollar Amount Of Two Percent Risk:

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

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

Actual Example In The Market Place:

MSFT is currently trading at $60.00 per share
Round trip commission is $ 80.00

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

Now the question is how many shares ("Trade Size") can we buy when our risk is $ 1.50 per share and our two percent account risk is $ 500.00?

The answer is:

  1. $ 500.00 minus $ 80.00 (commissions) = $ 420.00
  2. $ 420.00 divided by $ 1.50 (initial stop loss amount) = 280 shares

That means you should buy no more than 280 shares of the stock MSFT to maintain proper risk control and obey the 2% risk rule. If you trade future contracts or option contracts, you calculate your position size the same way. Note that your "Trade Size" may be capped by the margin allowances for futures traders and for stock traders.

Note that MSFT which is Microsoft is a technology company in the technology sector. It is important that if you want to take another trade while you are still in the Microsoft trade, that you trade a different sector of the market. This same rule applies to options and futures as well. In futures trade a different commodity. So, basically using these rules you will be automatically diversified.

Also note that if your risk in one sector is only one percent, you may take additional trades in that sector until you reach a total of two percent. You should not exceed six percent overall between all sectors. In other words, the most or total account portfolio risk you should have at any given time should not exceed six percent. Remember the two percent risk must include commissions and if possible slippage, if you can determine that. Using this technique will also keep your trade and risk in proportion to your trading account size at all times.

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 trade another market. So, multiple positions can be possible.

Trading Capital – Funding Your Trading Account

It is alarming that many traders use either borrowed money or money they really cannot afford to lose or risk. This usually will set the trader up for failure because they will be subject to the market’s emotional manipulation since the trader cares too much about the outcome of each trade.

In simpler terms, the trader is nervous about losing the money and therefore each stop out creates more anxiety up to a point where the trader may not want to get out when suppose to and take the loss, but instead hope the trade comes back. It takes both responsibility and discipline for accepting the trading loss and getting out. This is the same type responsibility and discipline the trader did not have when he or she decided to trade with money that shouldn’t be traded. So, it is not likely the trader will have the discipline nor have the responsibility to trade successfully. If you do not have sufficient risk capital to trade, begin "Paper Trading" to improve your trading 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 so that you will do better.

The Psychology Behind "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.

"Scaling" out of trades is a great technique that actually can convert some losing trades into profitable ones, reduce stress, and increase your bottom line! As you all know by now, I am a big advocate of reducing stress while you’re in a trade. This way you can focus on the trade and not be subject to emotions such as fear and greed which usually hamper your trading. Properly "Scaling" out of positions can not only at times make you more profitable, but it can also reduce the stress that some traders incur during trading.

In order to "Scale" out of trades the 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 key here is that the initial position must be large enough to enable you to cover your profitable trade in increments without incurring additional risk form such a large opening position. Remember, we want less stress, not more!

Your initial position or "trade size" should always be within a 2% risk parameter. Therefore, the key now is be able to initiate a large enough "trade size" while not risking more than 2% on entering the trade. There is only 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 size based on a 2% or less loss if this initial position is stopped out. The other way, is to add additional trading capitol 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, this method could lead to increasing your stress!

Here is an overview of "scaling" out of a position and how it can help your trading. This technique works on all time frames from intra-day to long-term term monthly charts!

"Scaling" Out Example

Let’s choose the e-mini as an example. In our example, your account size is $25,000 and you choose to risk 2% on this trade. 2% of $25,000 is $500. Your trade entry is 1037.75 and your exit is 1036.25 so you can buy approximately 6 contracts and stay within your risk parameters. Now this means if you get 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 and therefore, this potential risk should not create any stress. Note, that if you add risk capitol to this trading account, you would be able to increase your initial "trade size" and still maintain a 2% risk. Let’s say we enter this trade and it starts to become profitable. Here is where "scaling" out comes in and there are many variations to "scaling" out, so you will need to "paper trade" this technique to find which way works best for you. The idea is, as soon as the trade is profitable enough, 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 some more contracts to lock in more profit as well. The idea here is that as soon as your trade is profitable enough; liquidate enough contracts so that even if your original stop-loss is triggered, you make a profit. If your initial stop-loss is never triggered, then you should be able enjoy the rest of the trade and let it go as long as the trend takes it knowing that no matter what happens, you should at least make a profit on this trade. Knowing this is a great feeling and you will even have more fun trading!

There are many variations and themes on how to "scale" out, but this is the basic idea. If you trade only one or two contracts you really can’t "scale" out of positions that well. This is another reason why larger trading accounts have an advantage over smaller ones! Also, some markets are more expensive then others, so the cost of the trade will also determine your "trade size." Remember in choosing your market, liquidity is important, and you must have sufficient market liquidity as well to execute "scaling" out of positions in a meaningful way. Poor fills due to poor liquidity can adversely effect our "scaling" out technique.

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 the remaining positions.

Here is an example of using multiple money management techniques. In the chart below we adjust stops and "scale" out of the trade in increments as part of our money management program. The initial "trade size" was calculated using a 2% risk based on the trade entry and the initial stop-loss point as indicated on the chart.

Bennett McDowell is founder and president of TradersCoach.com. He developed the Applied Reality Trading® (ART® software and home-study course, featuring the Pyramid Trading Point® indicator. These products are now used by traders worldwide and the ART® trading system has been favorably reviewed by a number of industry publications, including Stocks & Commodities magazine and Traders World magazine. Mr. McDowell was recently honored to be included as a member of the eSignal "Trading With The Masters" team, and his company, TradersCoach.com, received a Stocks & Commodities "Reader's Choice Award" in 2005. Considered an expert in technical analysis and complex trading platforms, he lectures nationally and writes articles for many leading trading publications and Web sites. Mr. McDowell began his financial career on Wall Street with J.J. Kenny Co., then became a Registered Securities Broker and financial advisor for Prudential Securities and Morgan Stanley.

Bennett McDowell is founder and president of TradersCoach.com. He developed the Applied Reality Trading® (ART® software and home-study course, featu...

Sharky

Admin
5,556 293
In this article Bennett discusses the principles of implementing sound money management techniques.
 

ibbu007

Newbie
2 0
risk mgmt is the most important aspect of trading if you want to play the game time & again.

this article has given some basic points on it.

though, i have personally seen very few traders applying it.
 

Silent.Trader

Member
80 1
The author mentions several issue's to consider. Unfortunately he seems to have little understanding of the subject. Take the statement: "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."
A lot is suggested in this phrase, but even with perfect risk management and low risk levels risk-of ruin is not zero.

Another phrase: "It has nothing to do with leverage, and in fact you can use leverage and still stay within a two percent risk of equity in your trading account." The author gives an example for microsoft stock, so I've to assume this statement should be valid for stock and stock related vehicles. To me it sounds completely ludricous for most instruments and for stock in particular. How can anyone limit risk to 2% trading stock while to my knowledge it has happened in the past that a broad stock index closed and opened the day after 30% below the previous close? For sector indexes and individual stocks this opening gap may even be higher. Trading individual stock you should imho seriously take into account that they may plunge 90% and more overnight. When leverage is applied you may consequently loose more than your trading account.

It's a statistical fact that when trading for an infinite time eventually, in the long run, you will loose everything unless trading deleveraged. Even perfect riskmanagement is not able to prevent this. Proper risk and money management and choosing lower risk of course increases your chances of survival. If a trader takes a risk of bankruptcy of on average once in 10 000 years there's a fair chance he won't live to see the event. If the trader however chooses a riskprofile that leads on average to banckruptcy once in every five years his chances to survive his life time are meagre.
 

tireg

Junior member
21 3
Brings up the ongoing debate about scaling-out vs. pyramiding on ;)
 

Silent.Trader

Member
80 1
tireg said:
Brings up the ongoing debate about scaling-out vs. pyramiding on ;)
I don't really know, but rationally I would say no to both. I'ld say you get in at the moment the opportunity occurs and your (perceived) risk/reward is at its peak.. Scaling in/out is from this point of view nonsense as the risk/reward ratio would be sub optimal. You might of course choose to implement 2 systems. One with a higher risk and one with a lower risk , this may result in scaling in/out as those systems provide you with different entry and exit signals. Personally I would not consider that scaling in/out but a diversification over systems and I would prefer to trade different products with those 2 systems.
 

TWI

Senior member
2,527 252
As far as I am concerned scaling in and out is not a problem and is essential when the size you trade is too large for the liquidity to sustain a single entry/exit point. Taking out 1/2 or 1/3 position at targets can substantially improve you equity curve volatility and is good for the mind.
 

Silent.Trader

Member
80 1
Good for the mind is imho not a good reason, it's emotional and consequently sub optimal. I thinks the target should be rational reasoning.

Liquidity may be a valid reason for fased entry and exit. For me barely an issue however as I 'm only a small retail trader , mainly active in fairly liquide markets and usually only with limit orders.

If scaling in and out really makes a difference for your equity curve I think you would be better of diversifying more. IMHO it would mean you're trading too large a size.
 

turtle trader

Active member
172 6
Silent.Trader said:
Good for the mind is imho not a good reason, it's emotional and consequently sub optimal. I thinks the target should be rational reasoning.

Liquidity may be a valid reason for fased entry and exit. For me barely an issue however as I 'm only a small retail trader , mainly active in fairly liquide markets and usually only with limit orders.

If scaling in and out really makes a difference for your equity curve I think you would be better of diversifying more. IMHO it would mean you're trading too large a size.
I'm also a small retail trader, but find that scaling out of positions has been of enormous benefit since I started to do it. It allows me to take a profit on a relatively high %age of trades (by setting an achievable 1st target) whilst also allowing me to catch a decent slice of the larger moves.

As TWalker points out, this has improved my equity curve considerably, both in terms of outright profitability & reduced drawdown.

Simon
 

Grey1

Senior member
2,186 177
Robert ,

The article started with a very sound advise and I was pleased to read it .

How ever :-

The 2 % rule is naive and does not bring volatility of the instrument into the equation .. Example ... MSFT has an ATR of say 20C while GOOG can have an ATR of $2.. You can NOT allow the same amount of stoploss for both stocks . Other side effects of not using VOLATILITY in calculating the correct position size is , one would not be able to HEDGE INSTRUMENTS correctly and PROPORTIONALLY against each other .

I have already outlined a very simple Position sizing technique in my previous posts .
 

rdstagg

Active member
207 3
A very good article if only it gets people talking sensibly about MM!
I think more emphasis should be placed on the "when there is sufficient profits.. scale out" idea. Its no good risking a dollar and scaling out at 50c.
I think mathematically scaling out does not work but psychologically and in reality with larger size its a must.
This is not a plug but simply go back and retest all your trades scaling out and not scaling out - Van Tharp quite rightly says you would make more money not scaling (subject to a positive expecatancy system).
My own experience is that psychologically it is much easier to scale out.
 

Dispassionate

Member
98 1
tireg said:
Brings up the ongoing debate about scaling-out vs. pyramiding on ;)
Scaling in has tremendous benefits if u are a trend-follower. Basically you want to press ur bets when the odds are in your favour in the same way a blackjack counter does(i.e. when there is increased odds of continuation of the trend)

Generally I do not scale out, it does make the position more volatile, but when I win, I win BIG!
 

fildi101

Junior member
16 1
An alternative to scaling in and out of a position is be to trade an instrument with multiple "independent" positions... something I'm papertrading/testing right now.

I generate my signals each night from the daily charts, based on a couple of basic indicators.. normally one per stock on my list (plus stops). For my experiment though, I'm using slighty adjusted variables for the indicators .. (eg W%R 11 day,12day,13 day), and creating mutiple sets of orders. if there's 5 variations to the indicators, I'll trade 1/5 of my planned maximum size on each one, so may exposure at any given time varies. I've only been running it a few days so it's too early to say how it works...but it'll be interesting to see..

an alternative would be to trade signals from the 1,2 and 3 minute bars, or the 10,15 and 20 minute... of course this might not be feasible for some styles of trading..
 

Charlton

Experienced member
1,501 325
Scaling out is reactive rather than proactive

The article provides general basic sound advice, but the words that fly out at me from the article about scaing out are:
- psychology
- reducing stress
- not be subject ot emotions such as fear and greed
- knowing this (that you have taken a profit) is a great feeling

As Silent Trader pointed out the psychological aspect is not sufficient reason and I particularly like his term "Sub optimal".

Taking this approach to trading is short-term. Scaling out IMHO means that you fear loss. Why do you fear it?

There are 2 reasons:
- you have not succeeded in eliminating the emotional - those persona that are not conducive to trading OR
- your exit strategy is ill-defined

I have been exploring the former on other threads, so will not repeat that here. In scaling out we are looking at a trending market and by scaling out you are effectively saying "my exit strategy cannot identify with any reasonable degree of certainty when this trend will end".

Scaling out is reactive, rather than pro-active. Acceptance of scaling out simply masks the problem that your exit strategy does not have as accurate a predictive power as it should.

I can understand the attraction of it, but it should be regarded, at best, as a short-term and amateurish solution.

Chalrton
 

CYOF

Experienced member
1,114 31
It is a difficult one to answer - and will IMHO be dependant on the individual and the approach taken.

I like Grey1's idea of using the ATR to reduce your risk exposure when the average range changes - it is important to note that this is averaged over 3 time-frames and you are more likely to be on the right side of the trend (not sure if this is right but Grey1 can clarify if not).

The real professionals - the MM's and Specialists - are continually adding to and taking away from positions, as they work on an average cost basis.

But again, as I have only traded fixed lots for a very short time frame - its an all or none situation - I am not qualified to offer good advice.

Grey1 seems to have it worked out in relation to the scaling in and out for controlling risk - but I would also think that there are other ways to do it. The question should be - do I want to go off and find some other way, or will I use a way that I can see is working - I think we will all have the same answer to this one, a no brainer really.

Hmm, I am back. It can also be dependant on your trading approach. If you are taking a position near the open, your strategy may be to add to positions at the "wiggle" pullbacks, providing the retracement does not take out the 5 day average wiggle for the stock. In this case you would not decrease your position - you would add to your position or exit when your trailing stop is hit - bottom of wiggle pull back.

So, it really does depend on the trader and the approach taken.

There is more than one way to skin a cat in the markets, finding the one that suits you best is probably the hardest part of trading.
 
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