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, traders must first believe that they need to implement this sort of program. Usually this belief comes after having a few large losses that cause enough psychological pain that the trader wants and needs to change. The trader needs to understand how improper “Trade-Size” actually hurt their 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 the trader believes and acknowledges that each trade’s outcome is unknown when entering the trade. Believing this makes the trader ask them self, how much can I afford to lose on this trade and not fall prey to the “risk-of-ruin?” 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.
No matter what trading system you are using, I highly recommend paying attention to your “Trade Size” on very trade. Not only will you be reduce the “risk-of-ruin” but you will more than likely trade with less anxiety knowing that if you do get stopped out at a loss, that loss should be in accordance with your risk acceptance levels. If you trade in this fashion, you are reducing stress and anxiety, leaving you able to focus on the market.
Bennett A. McDowell, founder of www.TradersCoach.com, began his financial career on Wall Street in 1984, and later became a Registered Securities Broker and Financial Advisor for Prudential Securities and Morgan Stanley. Bennett is considered an expert in technical analysis; he frequently lectures and recently authored the bestselling book The ART of Trading.