In my last article, I wrote about the importance of having a profit target significant enough to over come the statistical disadvantage of the bid / ask spread and contracts. The next and most important element of success in trading is the complete understanding of proper money management.
First, you must understand that a trading system generally gives some combination of buy / sell signals with target and stop loss levels or some combination thereof. Money management is a completely separate part of the system. It is not and does not have anything to do with the trading system. Money management is a SEPARATE system in itself.
For those of you new to trading; Money Management reiterates the decision as to how much of your trading capital to put at risk versus your trading capital.
Gambling Systems in Trading
Many new or beginning traders attempt to improve the results of their trading by using gambling based systems of doubling up after each losing trade or any of the many variations of these systems. Without going into dramatic detail here just consider this situation (and it is not uncommon)
Account Size: $ 10,000 Money Management Plan: Risk 5% on initial trade and Double Up after Each Loss
Trade Risk Loss End Balance
# 1 $ 500 – $ 500 $ 9,500
# 2 $ 1000 – $ 1000 $ 8,500
# 3 $ 2000 – $ 2000 $ 6,500
# 4 $ 4000 – $ 4000 $ 2,500
# 5 Not Enough
After 4 consecutive loses this trader has lost 75% of the trading capital and can not continue the system for lack of capital. You may argue that this trader will make money as long as they do not have more than 4 consecutive loses and this is true.
But study these Statistics:
Win Ratio ODDS of Losing 4 Consecutive Times
30% 1 in 5.71
40% 1 in 6.66
50% 1 in 8
60% 1 in 10
70% 1 in 13.3
If you give this some careful thought, you will easily see that over the course of a year and hundreds of trades the possibility of having four or more consecutive losing trades is nearly a certainty. My hope is by discussing this, it will discourage new traders from ever considering any of these doubling up systems. They are a certain road to ever losing your trading account.
Simple and Effective Money Management for Small Accounts
The best and most effective method of managing a small account is to make the first and most important concern to reserve capital. It is far more important to conserve capital than it is to swing for the fences. Many new traders make the mistake to leverage their accounts with far too much risk per trade in a feeble attempt to make the ridiculous gains touted by many outlandish systems on the market today.
I personally recommend the following: First: Risk no more than 3-5% of the trading equity in each trade!
Second: Risk more only once profits are banked into the account
Third: Risk less per trade should your account lose value.
Use the following Money Management formula in your trading regardless of your trading system:
(Beginning Balance X 3 to 5%) + (Profit Gained or Lost X 10%) = Max. Risk per Trade
Max. Risk per Trade / Stop Loss Amount = Max. Shares or Contracts to Trade
Using this formula you will see that all of the objectives have been met:
1. Should your trading account drop below the beginning balance, you will soon begin risking far less than the beginning 3 to 5% equity per trade.
2. As the account gains value, the formula allows for more risk and then compounding gains.
3. Once gains are banked, but a losing streak begins .. This formula immediately starts to reduce risk which preserves the gains in the account.
My hope is that this brief discussion of money management will spur you to give it serious study as this is EQUALLY as important as choosing a good positive expectation trading system. Most new traders are so busy searching for the wholly grail that they completely neglect the money management aspect of their trading and thus doom themselves to ever losing their trading capital. This is the primary reason that most new traders fail and must leave the trading game prematurely.