Money Management in 17 Steps
Traders ask me all the time about what my money management strategies are.
The good news is that for most traders, money management can be a matter of
common sense rather than rocket science. Below are some general guidelines that
should help your long-term trading success.
1. Risk only a small percentage of total equity on each trade,
preferably no more than 2% of your portfolio value. I know of two traders who
have been actively trading for over 15 years, both of whom have amassed small
fortunes during this time. In fact, both have paid for their dream homes with
cash out of their trading accounts. I was amazed to find out that one rarely
trades over 1,000 shares of stock and the other rarely trades more than two or
three futures contracts at a time. Both use extremely tight stops and risk less
than 1% per trade.
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2. Limit your total portfolio risk to 20%. In other words, if you were
stopped out on every open position in your account at the same time, you would
still retain 80% of your original trading capital.
3. Keep your reward-to-risk ratio at a minimum of 2:1, and preferably
3:1 or higher. In other words, if you are risking 1 point on each trade, you
should be making, on average, at least 2 points. An S&P futures system I
recently saw did just the opposite: It risked 3 points to make only 1. That is,
for every losing trade, it took 3 winners make up for it. The first drawdown
(string of losses) would wipe out all of the trader’s money.
4. Be realistic about the amount of risk required to properly trade a
given market. For instance, don’t kid yourself by thinking you are only risking
a small amount if you are position trading (holding overnight) in a high-flying
technology stock or a highly leveraged and volatile market like the S&P futures.
5. Understand the volatility of the market you are trading and adjust
position size accordingly. That is, take smaller positions in more volatile
stocks and futures. Also, be aware that volatility is constantly changing as
markets heat up and cool off.
Never add to or “average down” a losing position
6. Understand position correlation. If you are long heating oil, crude
oil and unleaded gas, in reality you do not have three positions. Because these
markets are so highly correlated (meaning their price moves are very similar),
you really have one position in energy with three times the risk of a single
position. It would essentially be the same as trading three crude, three heating
oil, or three unleaded gas contracts.
7. Lock in at least a portion of windfall profits. If you are
fortunate enough to catch a substantial move in a short amount of time,
liquidate at least part of your position. This is especially true for short-term
trading, for which large gains are few and far between.
8. The more active a trader you are, the less you should risk per
trade. Obviously, if you are making dozens of trades a day you can’t afford to
risk even 2% per trade–one really bad day could virtually wipe you out.
Longer-term traders who may make three to four trades per year could risk more,
say 3-5% per trade. Regardless of how active you are, just limit total portfolio
risk to 20% (rule #2).
9. Make sure you are adequately capitalized. There is no “Holy Grail”
in trading. However, if there was one, I think it would be having enough money
to trade and taking small risks. These principles help you survive long enough
to prosper. I know of many successful traders who wiped out small accounts early
in their careers. It was only until they became adequately capitalized and took
reasonable risks that they survived as long term traders.
This point can best be illustrated by analyzing mechanical systems
(computer-generated signals that are 100% objective). Suppose the system has a
historical drawdown of $10,000. You save up the bare minimum and begin trading
the system. Almost immediately you encounter a string of losses that wipes out
your account. The system then starts working again as you watch in frustration
on the sidelines. You then save up the bare minimum and begin trading the system
again. It then goes through another drawdown and once again wipes out your
account.
Your “failure” had nothing to do with you or your system. It was solely the
result of not being adequately capitalized. In reality, you should prepare for a
“real-life” drawdown at least twice the size indicated in historical testing
(and profits to be about half the amount indicated in testing). In the example
above, you would want to have at least $20,000 in your trading account, and most
likely more. If you would have started with three to five times the historical
drawdown, ($30,000 to $50,000) you would have been able to weather the drawdowns
and actually make money.
10. Never add to or “average down” a losing position. If you are
wrong, admit it and get out. Two wrongs do not make a right.
11. Avoid pyramiding altogether or only pyramid properly. By
“properly,” I mean only adding to profitable positions and establishing the
largest position first. In other words the position should look like an actual
pyramid. For example, if your typical total position size in a stock is 1000
shares then you might initially buy 600 shares, add 300 (if the initial position
is profitable), then 100 more as the position moves in your direction. In
addition, if you do pyramid, make sure the total position risk is within the
guidelines outlined earlier (i.e., 2% on the entire position, total portfolio
risk no more that 20%, etc.).
12. Always have an actual stop in the market. “Mental stops” do not
work. Strive to keep maximum drawdowns between 20-25%
13. Be willing to take money off the table as a position moves in your
favor; “2-for-1 money management1” is a good start. Essentially, once your
profits exceed your initial risk, exit half of your position and move your stop
to breakeven on the remainder of your position. This way, barring overnight
gaps, you are ensured, at worst, a breakeven trade, and you still have the
potential for gains on the remainder of the position.
14. Understand the market you are trading. This is especially true in
derivative trading (i.e. options, futures). I know a trader who was making quite
a bit of money by selling put options until someone exercised their options and
“put” the shares to him. He lost thousands of dollars a day and wasn’t even
aware this was happening until he received a margin call from his broker.
15. Strive to keep maximum drawdowns between 20 and 25%. Once
drawdowns exceed this amount it becomes increasingly difficult, if not
impossible, to completely recover. The importance of keeping drawdowns within
reason was illustrated in the first installment of this series.
16. Be willing to stop trading and re-evaluate the markets and your
methodology when you encounter a string of losses. The markets will always be
there. Gann said it best in his book, How to Make Profits in Commodities,
published over 50 years ago: “When you make one to three trades that show
losses, whether they be large or small, something is wrong with you and not the
market. Your trend may have changed. My rule is to get out and wait. Study the
reason for your losses. Remember, you will never lose any money by being out of
the market.”
17. Consider the psychological impact of losing money. Unlike most of
the other techniques discussed here, this one can’t be quantified. Obviously, no
one likes to lose money. However, each individual reacts differently. You must
honestly ask yourself, What would happen if I lose X%? Would it have a material
effect on my lifestyle, my family or my mental well being? You should be willing
to accept the consequences of being stopped out on any or all of your trades.
Emotionally, you should be completely comfortable with the risks you are taking.
The main point is that money management doesn’t have to be rocket
science. It all boils down to understanding the risk of the investment,
risking only a small percentage on any one trade (or trading approach) and
keeping total exposure within reason. While the list above is not exhaustive, I
believe it will help keep you out of the majority of trouble spots. Those who
survive to become successful traders not only study methodologies for trading,
but they also study the risks associated with them. I strongly urge you to do
the same.
In the final installment of this series, we will question successful traders
about their insights on proper money management.
Dave Landry
is principal of Sentive Trading, a money management firm, and a principal of
Harvest Capital Management. Mr. Landry is the author of two top selling books,
“Dave Landry’s 10 Best Swing Trader Patterns And Strategies” and “Dave Landry On
Swing Trading.” His website is
www.davelandry.com.