Money Management – A Crucial Aspect of Trading

Many traders believe that the obvious way to make money is simply to have more winners than losers, but this is too simplistic, and what often trips up the unwary player is a lack of money management and attention to risk. Clearly, entering positions correctly and where to place stop losses are of great importance, but one area that is rarely examined because it is very complex is money management, and the reason is probably quite simple.

Certain trades or investments appeal to different people, and who is to know what their overall financial position is before giving them the correct advice on what amount to trade or invest. Furthermore, it is very easy for an investor to confuse a trade with a portfolio investment of stocks, or make a long term purchase but with one eye on a quick buck. For these reasons, money management rules must be adhered to for each trade.

A typical experience

One of the experiences many of the great traders have in common is that they blew a fortune early on, simply because they had no conception of money management. A typical story was that they had traded well, running a sum of say $10,000 up to $15,000 in six months, and they began to think that because they had a good trading system, they would have done better by leveraging up for super fast profits. In some cases they simply doubled up trading positions, but ran into a string of losses. As they did not reduce trading size accordingly, the account equity was wiped out and they ended up actually owing money within days – it was that quick.

For sure, they probably were not limiting risk with stop losses, but in some cases the share or commodity gapped up or down, and just one big trading position was all it took to blow away months of hard work.

Extreme events and the problems they can cause

One of the more remarkable aspects of trading is the frequency of extreme events, but these are simply statistical anomalies which occur with random regularity (forgive the lapse into chaos theory, but it’s important). There have been instances of a doubling of a share price overnight – this occurred with Psion twice in 1999. At the other extreme, there was a fall of 70% in a day with Marconi on the 21st March 2002, where they opened at 92.5p (adjusted for share consolidation), and the next day hit 27.5p. At the time, these were both FTSE 350 stocks at the time, and not small companies.

How to reduce the risk of wipeout

These might be extreme examples, but the bottom line is that events often happen when you least expect them. You must treat your trading account as distinct from all other investments, and once you’ve done this, there are three things you can do:

1. Accept that occasionally there will be an extreme event, so if the worst that can normally happen is a 30% fall on a profit warning, or an equivalent rise on a bid overnight, work out how much that would impact your equity.
2. Don’t feel that by buying five blue chips of equal amounts, you’ve diversified your risk - if they are highly correlated i.e. high beta stocks, or they are all tech stocks, then it is virtually the same risk as buying five times the amount in one stock.
3. If your equity is falling, and statistically you can expect a run of eight or more losses in a row more than once within a typical trading lifetime, keep reducing your size until you start winning again.

How much should you risk on each trade?

From experience, if you aim to lose an absolute maximum of 5% of your account equity on one trade, and combine a wide range of trades in different asset classes with long and short positions, then you should have at least 20 consecutive attempts before it’s time to give up.

So if you have to set a stop loss on a volatile share which is wider than normal, then simply reduce the trade size for that share so that your maximum loss is no higher than usual. Furthermore, if you do run into a string of losers, if you keep reducing position size, then your losses will slow down.

Finally, all trades should be treated in the same way, and if you don’t feel that a potential trade looks as good as others in your list, then don’t do it. The converse is that you must take every trade that fits your entry criteria, whether or not you have won or lost recently. The whole point is that a good disciplined system will only work when all trades are taken with equal amounts using realistic targets, stops and money management.

Mike Estrey is the Head of Research for Blue Index, the Day Trading specialists in Contracts for Difference. Foreign Exchange Trading also forms part of their extensive services.