What exactly is Money Management in Trading?

[StupendousTrader]

I have two questions regarding Money Management and here they are:

1. What exactly do we mean by Money Management in Trading Stocks, Options, Commodities and Forex?

2. How do we optimize our trading funds to get the best bang for our money?

Now, I want to clarify a few things. Money Management is related to bet or position sizing but it is not position sizing. Money management also relates with stop placement but it is not stop placement. Money Management is actually a subset of risk management but it is not risk management. It is only in question 2 that you can create a relationship of Money management with position sizing, stop placement, risk Management or anything else to optimize the trading funds.

With the above clarifications, let's see if we can finally understand Money Management as a collective group and use it for our benefit. It is one of the most important aspects of trading. Do not be shy to express your opinion. Sometimes assumed stupid answers turn out to be the gem in rock.

Let's go for it.

 

[Nut]

In my mind using money management is to acknowlede that risk exists, that the makets contol the traders and irrespective of how good an analyst an individual might be he/she is going to be wrong sometimes.

Cheers
Nut

 

[Charlton]

I have two questions regarding Money Management and here they are:

1. What exactly do we mean by Money Management in Trading Stocks, Options, Commodities and Forex?

2. How do we optimize our trading funds to get the best bang for our money?

Now, I want to clarify a few things. Money Management is related to bet or position sizing but it is not position sizing. Money management also relates with stop placement but it is not stop placement. Money Management is actually a subset of risk management but it is not risk management. It is only in question 2 that you can create a relationship of Money management with position sizing, stop placement, risk Management or anything else to optimize the trading funds.

With the above clarifications, let's see if we can finally understand Money Management as a collective group and use it for our benefit. It is one of the most important aspects of trading. Do not be shy to express your opinion. Sometimes assumed stupid answers turn out to be the gem in rock.

Let's go for it.

I agree with your analysis of the multi-facetted nature of money management and risk management.

We aim to identify a setup and an exit strategy that has a high probability of profitability. Skill and experience should increase the probability in our favour, but the market is chaotic and our exit strategy should acknowledge both our level of skill and market nature through money and risk management.

There is perhaps a psychological barrier to overcome. Risk and money management reminds us of what can go wrong - the negative. This is perhaps why it doesn't always get the attention it deserves. If we turn the psychology on its head and regard it as a positive contribution that increases profitability in the long run then it should benefit our accounts. Indeed by giving it more attention it should also help us to focus on the rest of the strategy. For example, if we find that an aspect of our money management e.g. hitting of stops too frequently is occurring, then we might ask the question is the money management wrong or is the entry/exit strategy wrong ?

Charlton

 

[Paul71]

I agree with your analysis of the multi-facetted nature of money management and risk management.

We aim to identify a setup and an exit strategy that has a high probability of profitability. Skill and experience should increase the probability in our favour, but the market is chaotic and our exit strategy should acknowledge both our level of skill and market nature through money and risk management.

There is perhaps a psychological barrier to overcome. Risk and money management reminds us of what can go wrong - the negative. This is perhaps why it doesn't always get the attention it deserves. If we turn the psychology on its head and regard it as a positive contribution that increases profitability in the long run then it should benefit our accounts. Indeed by giving it more attention it should also help us to focus on the rest of the strategy. For example, if we find that an aspect of our money management e.g. hitting of stops too frequently is occurring, then we might ask the question is the money management wrong or is the entry/exit strategy wrong ?

Charlton

Mooning.

can a person can be an absolute crap trader, no good at identifying much except a general trend (if one should exist), and yet, with MM alone, make money from the market?

I think you can, in fact, i do!

 

[Splitlink]

My personal interpretation of money managrment is the conservation of capital. If I'm in a losing trade, to get out before the financial loss becomes a worry. Worry and successful trading do not mix well.

Last month I made 198 points trading Footsie. I have not been much good at it in the past but come back when I have a new idea. So far, this month, I am down 28 points, with 30 losing trades. If I had had far away stops, or just waited, hoping that the trade would get better, I would have been cleaned out by now. I am disappointed, but not worried. Money management, for me, is about that. I know that I am capable of gaining more than 30 points in the five hours that I have to trade every day and am working on my entries, in the knowledge that my losses are under control.

I always remember a T2W article that said. The losses are the only thing in a trade over which the trader has control. He can enter a trade knowing how much he is prepared to lose.

Split

 

[Trader333]

....hitting of stops too frequently is occurring, then we might ask the question is the money management wrong or is the entry/exit strategy wrong ?

I would say that in this case the stop is not correct for the volatility of the instrument being traded.


Paul

 

[Paul71]

I would say that in this case the stop is not correct for the volatility of the instrument being traded.


Paul

If stops are getting hit frequently?

Mmmm, this is due to bad timing on the traders behalf or bad stop placement. What about R:R ratios, Paul, do you think trying to squeeze to much out can lead to bad trades and stops?

 

[Splitlink]

I would say that in this case the stop is not correct for the volatility of the instrument being traded.


Paul

Would you not say that the average amount of the winning trades, and the number of them, will help determine what loss is acceptable? I reckon that my 28 point loss on the month could be liquidated with one good trade. I do think that my stops could be a bit close but, if I increase the distance, it makes it that much more difficult to recover.

Experience tells me that, in my case, only being able to trade in the mornings, getting more than 40 points is an exceptional circumstance, while 30 points is very possible and 20-25 is common on winners. Nevertheless, there are lot of losers, that is the problem!

Regards

Split

 

[damianoakley]

Hi,

I would say that it would be very difficult to describe "money management" in one simple sentence.

It has almost become a throw-away phrase in trading that is over-used in conversations and has now lost its meaning.

Money Management encompasses such a broad range of separate topics that it is difficult to define.


Thanks

Damian

 

[timsk]

A definintion . . .

Risk management focuses on the steps necessary to minimise losses by assessing market conditions, risk-reward, probability and the use of stop loss orders etc. Money management, on the other hand, focuses on the steps necessary to maximise profits by the use of trailing stops and adjusting position size etc. This is summed up perfectly in that giant of trading axioms: ‘cut your losses short (i.e. risk management) and let your profits run' (i.e. money management).
Tim.

 

[Charlton]

Mooning.

can a person can be an absolute crap trader, no good at identifying much except a general trend (if one should exist), and yet, with MM alone, make money from the market?

I think you can, in fact, i do!

This is a point that Douglas makes in Trading in the Zone. I can't find the exact references at present, but basically if you can swing the balance of probabilities even just slightly in your favour and accompany it with good money management then you stand a chance of taking money out of the market. Identifying a general trend may tilt the balance and the more you can tip the scales the better.

Charlton

 

[zupcon]

Mooning.

can a person can be an absolute crap trader, no good at identifying much except a general trend (if one should exist), and yet, with MM alone, make money from the market?

I think you can, in fact, i do!

This is a difficult question to answer. Firstly I think you have to consider the role of luck both good and bad in these types of scenario's. I think if you took a large enough sample of crap traders, then the results would speak for themselves, MM even if correctly applied just prolongs the agony. Then again, there will clearly be people who dont have the first clue absolutely raking it in, its just the way probabilities play out sometimes.

I'd also probably argue that anyone who can identify a trend, and correctly assess risk is very far from an absolutely crap trader

regards
zu

 

[StupendousTrader]

Money Management is not difficult to describe

Hi,

I would say that it would be very difficult to describe "money management" in one simple sentence.

It has almost become a throw-away phrase in trading that is over-used in conversations and has now lost its meaning.

Money Management encompasses such a broad range of separate topics that it is difficult to define.


Thanks

Damian

Money Management is not difficult to describe and it does not encompass a broad range of topics. Money management means managing your money. And money is cash or any tangible asset that is very liquid. Your stock, commodity, Currency pair or option is not money. You cannot take a stock to the grocery to buy food. Until you sell your stock, it is not money. It's as simple as that.

In this particular instance, we are talking of Trading fund as our money. Let's assume you as a Stock Trader have $100,000 trading fund (Money) to trade stocks and make a profit. This means your job is to manage this money profitably. The way you handle this $100,000 is what we call Money management. When I use to trade stocks, I normally used 40% of my funds (Money) to trade. This means, I am using $40,000 out of the $100,000 to trade, leaving $60,000 as a reserve.

Presently, I specialize in Commodity Futures Spreads because the returns are phenomenal compared to stocks, options, commodities and even Forex. For the $100,000, I use a maximum of 25% or $25,000 to trade leaving a solid cushion of $75,000 for protection.

These two scenarios, I have described are money management vis-a-vis, trading. The driving force for this money management is capital preservation or capital appreciation. If you are in the capital preservation mode, you will use only a tiny fraction of the $100,000 but if you are in the capital appreciation mode, you will use a larger fraction to trade.

Whatever mode you are in, you will now relate the fraction of money you are actually trading with to bet sizing, stop placement and risk management. This is no longer Money Management but Bet Sizing and Money Management; Stop Placement and Money Management; and Risk and Money management or Actual Trading Capital Risk Management.

With the above clarification, we come back to my second question, which I will now break down:

1. How do we relate bet sizing to Money Management (our actual trading capital of say $25,000 out of the $100,000)?

2. How do we relate stop placement with this same Money Management?

3. How else do we manage the risk of our actual trading capital ($25,000 of the $100,000) to avoid losing all $25,000 or even more? In other words, how do we relate whatever other risks there are to this same Money Management?

It does not matter whether you are trading Stocks, Options, Commodity Futures or Forex, money management is money management. The differences are in the fractions of your funds you actually trade with and the number of contracts or positions.

Let's be realistic and come up with real practical solutions to all 3 questions above. Who knows, we may all learn a lot and trade more profitably.

 

[Trader333]

Would you not say that the average amount of the winning trades, and the number of them, will help determine what loss is acceptable?

My view is that before any trade is taken each person needs to have decided what is an acceptable loss and for me this is the very low level of only a half of 1% of my capital. Now in addition to this position sizing should be adjusted to market volatility in the timeframe being traded so that regardless of timeframe your risk is always the same.

So if you place a 10c stop for an instrument that you are trading that has a volatility of 30c in the timeframe being traded then your stop will get hit almost all the time. But if you determine that the volatility of your instrument is only 5c in your chosen timeframe and set a stop at 10c then again you are setting your stop too far away.

Dynamic position sizing relative to instrument volatility is of critical importance in money (and risk) management in my view. Setting a fixed level of stop measured in points, cents, pips or whatever has never made any sense to me but I accept that it may well work for some people.


Paul

 

[timsk]

My view is that before any trade is taken each person needs to have decided what is an acceptable loss and for me this is the very low level of only a half of 1% of my capital. Now in addition to this position sizing should be adjusted to market volatility in the timeframe being traded so that regardless of timeframe your risk is always the same.

Agree.

So if you place a 10c stop for an instrument that you are trading that has a volatility of 30c in the timeframe being traded then your stop will get hit almost all the time. But if you determine that the volatility of your instrument is only 5c in your chosen timeframe and set a stop at 10c then again you are setting your stop too far away.

Not sure about this. Perhaps I've misunderstood you, but your comment infers that, say, a daytrader who trades a volatile Nasdaq stock which typically moves a full dollar or more in any one day ought to set their stop at least a full dollar away from their entry? I don't know of anyone who does this. Most U.S. daytraders that I know of have tight stops on fairly volatile instruments and, contrary to your suggestion, they don't get hit all the time. The reason for this, I believe, is that they factor in the probability of the instrument moving into profit before their stop is hit. The secret of their success is that they manage to get this bit right more often than they get it wrong.
Tim.

 

[Splitlink]

Thanks for this thread.

Split

 

[Trader333]

Not sure about this.

Tim,

I know that you have read the comments from Grey1 concerning this view and had exchanges with him about this subject. I am a firm believer in the approach he adopts with regard to this and although you may have a different view, all I can say is that this approach works well. As such I am unlikely to be persuaded by the view that you can have a small stoploss for massive gains in profit. I am also a seasoned Nasdaq stock trader and so I do have a good understanding of how these stocks move and the necessary risk reward strategies that work. I am curious to know if you have actually traded Nasdaq stocks and if so how have you found it ?


Paul

 

[searchlight]

I think you have to have one crucial information in your disposal in order to manage your trading account effectively. That is your success rate. Everything else flows from there. Ones the success rate known risk/reward ratio becomes determining factor.

Lets take 25% success rate. ( "crap" for anybody's standard ) We will also assume that account is well capitalized to withstand long loosing period inevitably will occur with this success rate. If our r/r ratio 1:3 we will breakeven ( not counting expenses ).
when expenses are taken in to account( commissions,spreads,etc ).we can see that financially speaking we will slowly bleed to death. Even risking 0.5 % per trade won't help. Death will be slower.
On the other hand if we have a r/r ratio of 1:4 or better ; on the long run we will make a profit, by risking same amount of trading capital as above.So one can be a "crap" in his/her trade selection but profitable at the same time.
Discipline is crucial here.Any trade less than 1:4 ratio won't be taken even our system/setup says so. Even the winning trades will lead to financial ruin in the long run if we lose our discipline.
Finally; everything being equal let the some genius have 100% success rate with the r/r of 1:1, while you mortal having 50% success rate with the r/r of 1:5.

You will have half the success, twice the money. Not bad eh.

regards,

 

[Hoggums]

If you include stops as part of money management then yes it is just (if not more) important than your entry method.

For instance in my indicator thread we tested a simple 4hr RSI system with a 50 point trailing stop and it made quite a lot of money. We then tested the same system but with opposite trades. The expectation was that the system would lose - but in fact due to the trailing stops the reverse system also made money. It didn't do as well and suffered larger drawdowns - but it does show that a well positioned stoploss strategy can make you money.

 

[stevespray]

Good thread.

My feeling is that it is possible to define ‘money management’ very simply;

Money Management is a concept which, when applied, gives us a greater mathematical probability of remaining solvent and therefore gives our ‘trading edge’ the time needed to produce a profit over an extended period of time.

Money Management is purely a mathematical model which can be used to preserve capital for as long as possible. Money Management does not guarantee success but simply increases the probability of success.

With regard to trades – Money Management purely relates to the maximum possible loss from a particular trade. The movement and setting of stops whilst in a trade do not relate to money management – the movement of stops whilst in a trade relate only to the trading methodology of the system – it is very important that these two points are separated. Money Management simply relates to worst case scenario – for example; trade opens, goes immediately against you and keeps going with no chance of tightening stops…… What is the maximum acceptable loss? This would be a ‘money management stop loss’ since, if the loss were allowed to get bigger, the probability of irrecoverable drawdown becomes unacceptable.

In my experience proper money management surprises most people. This is why many people lose money in the long term. Tell these people to risk only 1% or 2% on a trade and suddenly the apparent glamour of being a stock trader disappears. Tell someone with a £5,000 spreadbetting account that they should only be risking £50 - £100 on a trade and they’ll laugh in your face. Probability dictates that, over a longer period of time, these folk will lose their money.

Successful money management will keep you in the game no if’s or but’s.

The most successful traders that I know are the ones who manage risk best. They are completely comfortable to take a series of small (pre calculated) losses. For me this is the true ‘key’ to trading if there is such a thing. The biggest mistake most people make when looking into trading is to search out methodologies which give great entry signals and the such – this is a fruitless search for a grail which does not exist. The key to successful trading is 90% based around managing your open trades. A good entry is of course an advantage but that advantage is completely wasted if you close the trade 5 minutes later to lock in a small win. This is why trade management is so important.

I know that it is said over and over that you should run winners and cut losses but this really is the true ‘key’ to success.

Steve.