Traders Toolbox: Money Management - Part 1 of 4

Crucial but often overlooked, money management practices can mean the difference between winning and losing in the markets.
Plenty of books, manuals, and software packages will help you form and opinion of a market, but not many will tell you how to trade once you have decided to get long or short. The goal of money management is to increase the odds of high quality trades. And as we'll see, leaving the money management variable out of your trading equation can lead to ruin, even if you're correct about the market direction.

In a broad sense, money management can encompass those elements of trading outside the initial decision to get long or short in a given market or markets – that is, how many positions to put on, when to get out, where to place protective stops. More specifically, it refers to the strategic allocation of capital to limit risk and optimize trading performance in the long run. Allocation of capital can refer to how much money to put into any one market or how much money to risk on any one trade. These decision directly affect how many positions to put on and where to place stop orders.
Given the negative odds inherent in trading (a successful trader can expect to lose money on 60% of his trades), how do you go about maximizing the profit potential of the few winning trades you can expect to have? The answers vary with the disposition and trading style of the individual trader. There exist, however, basic concepts that can be successfully adapted and modified to individual needs, and when the followed in spirit, can boost the promise of long-term trading profits and take some of the stress and uncertainty out of trading.
-Establish A Goal- Having a clear idea of what you want to accomplish by trading, whether it is a short-term profit on a single trade or the desire for a long-term trading career, can go a long way toward building successful trading habits. Regardless of whether or not the goals are set on a per trade, daily or long-term basis, establishing from the outset basic levels of acceptable risk and financial reward will help curtail avoidable risk and extreme losses. Also, determine a specific time frame in which to trade: Will a position have to be liquidated by a certain time for tax purposes or for same other reason?

-Diversification- Just as in the stock market, a portfolio of different instruments can be one of the best hedges against several and unsustainable losses; a loss in one market will hopefully be offset by gains in others. Traders must take caution, though, to truly diversify their portfolios with contracts that are price independent. Spreading your trading among three or four different interest rate contracts that move in a similar fashion is not a good example of diversification, because a loss in one contract is likely to be mirrored by losses in the others. But over-diversification is dangerous, too. A trader can spread his money over too many markets, and not have enough capital in any one of them to weather even small adverse price swings.
A good rule of thumb is to stick with what you are comfortable; do not venture blindly into unknown markets just for the sake of diversification. A balance must be stuck between available resources and a manageable trading scenario. Capital constraints will, of course limit the choices traders can make, forcing those with smaller trading accounts to bypass or minimize diversification.

6 thoughts on “Traders Toolbox: Money Management - Part 1 of 4

  1. couldnt you just determine how much you are willing to lose per trade eg $100 and divide by you stop to determine the number of shares eg 50 cents. 100/.5 = 200 shares. no worry.

  2. I agree but wanted to add that stops and exiting strategy are also very important. (Maybe this is in a later lessson, my apologies if so.)

    You must set your stops, and lean how to do so correctly. You must determine what your maximum amount of loss is per trade based on a percentage of portfolio(s).

    Below is a simplistic explanation that does not take diversification (or technical reasons) into consideration, but since you have already covered that part, the simple explanation will suffice.

    Let’s say you have a portfolio of 100,000 and will except a max 2% loss. This means you only risk $2000 of your capitol on a trade.

    If you buy 400 shares of XX at $25 ($10,000) per share and have a stop at $21 your max loss is 400 X $4 or $1600 this is acceptable (1.6% of total portfolio).

    But if you buy 700 of XX at $25 ($17,500) per share with a stop at $21 your max loss is 700 X $4 or $2800 (2.8% of your total portfolio). You have overstepped you max loss.

    You can adjust the amount of shares to fit the percentage. In some cases you may even want to use odd lots. However, adjusting the stops to fit the percentage is not the correct methodology. You must place stops for a good technical reason. Making them too tight will shake you out too early. (Of course you can always get back in later.)

    If you have no stops and “buy and hold”, you may watch your $25 per share go all the way down to $12, $10, or even $8 per share. This is a very bad alternative for obvious reasons; a few of these trades and your capitol is virtually gone. Such large losses are hard to recover and can take a great amount time.

    Why are stops so important? The importance is because, statistically, sooner later every trader will have 10 bad trades in a row. By limiting potential loss and having a good exit strategy you can stay in the game to play another day.

  3. How many different investments should you have to be diversified with out being too diversified? As well how much should you put in each trade? Should it always be equal amounts for example 5 different investments with little correlation and 20% in each a good mix?

    1. Dustin,

      Thank you for your feedback. I would say that the ideal number is somewhere between five and seven. Once you get over that many markets to watch it becomes too difficult to keep up with everything. I think it's a mistake to try to follow too many markets.

      I hope this helps.

      All the best,

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