Traders Toolbox: Money Management Part 2 of 4

Posted on by lindsay

Crucial but often overlooked, money management practices can mean the difference between winning and losing in the markets.

-Amount Of Money To Risk- It's difficult to come up with hard and fast money to risk on different markets and trades. For our purpose, though, it's best to think conservatively. Although some studies suggest initially allocating equity in broad terms of original margin (40% to 50% of total equity committed to the markets at a given time in the form of original margin, 15% to a particular market, 5% to a single trade, etc.), many traders consider these percentages too high, and do not consider the market to be a accurate measure of risk or a sound basis on which to allocate funds, because a trader can always, technically, lose more than the margin amount. These traders find it more beneficial to think in terms of the actual money amount they are willing to lose on any particular trade or trades, determined by their stop level or through some other calculation.

Although in specific circumstances professional traders may actually risk comparable or even greater percentages of total equity than those listed previously, on average they risk much less-perhaps 12% to 20% of total capital at a time, and 2% - 4% per trade. Depending on the size of your trading account, these levels might seem overly strict, but again, the idea is to conserve money for the long haul.

In developing your trading goal, determine how much you could accept losing on a trade, both financially and psychologically. Based on total capital and the number of markets in which you are active, allocate your equity proportionally between individual trade, market group and total trading activity levels.

These guidelines protect you from dangers of extreme leverage in the futures markets. Though it may seen attractive to have the change to make big money on a small initial investment, the risk of loss is just as great.

-Determining Reward/Risk Ratios- Another common rule in trading is never to put on a position unless your possible profits outweigh your possible losses by a ratio of 3 to 1, or at the very least 2 to 1. So, if a particular trade has the potential of losing $100, the profit potential should be at least $200 to $300. This is not a bad rule, but like so many aspects of trading, it is somewhat intangible. Once you have formed an opinion of a market, determined your entry point and calculated the maximum amounts you could win or lose on a trade, you still are left with the uncertainty of the probability of your trade winning or losing, and unfortunately there is not secret formula for removing this uncertainty.

Some traders don't consider probabilities valid at all. The most any trader can do is perform his or her best analysis of the market, and, along with experience and intuition, come up with some rough idea of the probability of success for a given trade. This probability can then be weighed against the reward / risk ratio in selecting trades. For example, would it be better to put on a trade where the reward / risk ratio is four to one and the probability of success is 30%, or would it be advisable to put on a trade where the reward / risk ratio is only two to one but the probability of success is 75%? Using this rule, you'll be ahead of the game by directing resources to the trades with the greatest chance of success.

9 thoughts on “Traders Toolbox: Money Management Part 2 of 4”

  1. I am in learning fase and surf the web for learning the techniques & tricks to trade. I started to follow the money management tool very strictly.

  2. As always, a sound view from Market Club. To me, margin,risk and account size are concepts unrelated with regard to a specific trade. The $1000 one may have to put up for a full lot at 100 to 1 are rarely at risk under conditions of sufficiently tight stop tactics. Some very experienced traders seem to put their initial stop way above the point they have designated as their worst fear of a move against their expectations, in order to guard against a toally unexpected price movement, like a spike. Once the price moves in a positive direction, they move their stop much closer to the action, to their real line of defense. Maybe the real task is find that second point.

  3. this article is useful because it directs ones attention to a very important aspect of trading.. But the larger questions it brings up, for example how does one make an educated guess about possible reward and loss metrics, on which the entire process is based, are not touched on at all.

  4. Some good ideas but, as a beginning swing trader, I have no idea whether a future, option, stock or ETF, or index will go up, down or sideways, let alone how far up or down. I can see how the principles outlined here would apply to a day trader or a scalper, but not so much to me.

    I limit each position to 5% of my account - which is a lot, I guess. But I set stops to lose no more than 2% of my account (not 2% of the trade) on each trade. I start out trading in several non-connected sectors but I will add progressively to winning positions, whether long or short, so that I may end up being not so diversified, as Adam Hewison recommends. I would appreciate anybody's comment on this. Thanks

    1. Hello,

      I'm new to trading. just joined marketclub recently & i'm very pleased with it. The educational blogs & videos on marketclub has been very useful for me to understand how one should trade. I had lost money before, but have been able to make some(more importantly not lost) after joining marketclub, though i'm still very much in the beggning of its learning process.

      About diversifying,it would be of great help to know, what the non-connected sectors/non-corelated markets are, that can be traded to diversify one's portfolio?

      i have heard Adam saying in one the videos that Oil & Apple are not corelated. Does it mean that all Technology stocks are not co-related with Oil?
      I intend to diversify my portfolio with at least 4-5 different non-connected sectors/non-corelated markets.

      Your responses are much appreciated. Thanks!

      1. Raj,

        Thank you for your feedback and welcome to MarketClub.

        I like your idea of diversifying between four or five different non-correlated markets. This is a strong part of a diversified portfolio and one that will help you in the future.

        Here's a look at what we call the perfect portfolio. It is a non-correlated approach to the market.

        Here is the link:http://club.ino.com/trading/2010/01/another-profitable-quarter-for-the-perfect-portfolio/

        All the best,
        Adam

        1. Hi Adam,
          I am very glad to be a member of your market club, as it has helped me in my trading positively. I have been able to be profitable, after using & following market club Triangle, in stocks & forex....

          I hope that u will not mind my writing it here.

          Regards
          Raj

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