INVESTNBEST



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|Implementing Money Management Techniques |

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|Implementing sound money management encompasses many techniques and skills coupled with judgment. These ingredients must be in |

|place before the trader is said to be using a money management program to trade. Failure to implement a good money management |

|program will leave the trader subject to the deadly “risk-of-ruin” exposure and lead 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 him or herself |

|to obscene risk because of an abnormally high “trade size.” |

|The trader (or, more appropriately “gambler”) may have gotten lucky and had 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 lead to that |

|probable equity bust or total loss I spoke of earlier. |

|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 his or her maximum “trade size.” If, on the other hand, the trader were calculating trade size, it stands to reason |

|that it would change from time to time. |

|To implement a money management program and help reduce your risk exposure, you must first believe that you need to implement this |

|sort of program. Usually, this belief comes after you’ve had a few large losses that cause enough psychological pain that you want |

|and need to change. You probably need to experience the ill effects to appreciate how improper trade size actually hurts your |

|trading. |

|Novice traders tend to think that the only good trade outcome is winning and, therefore, do not think about risk. Professional |

|traders focus on the risk and take the trade accordingly. Thus, “The Psychology Behind ‘Trade Size’” begins when you believe and |

|acknowledge that each trade’s outcome is unknown when you enter the trade. Believing this makes you ask yourself, “How much can I |

|afford to lose on this trade and not fall prey to the ‘risk-of-ruin’ outcome?” |

|When traders ask themselves that, they will do one of two things: Adjust their trade size or tighten their stop loss before |

|entering the trade. In most situations, the best method is to adjust your trade size and set your stop loss based on market |

|dynamics. |

|During “draw-down” periods, risk control becomes very important. Because good traders test their trading systems, they have a good |

|idea how many consecutive losses can occur in a row. Taking this information into account allows the trader to further determine |

|the appropriate risk percentage to take on each trade. |

|Let’s talk about implementing sound money management in your trading formula so as to improve your trading and help control risk. |

|The idea behind money management is that, given enough time, even the best trading systems will only be right approximately 60 to |

|65% of the time. |

|That means that 40% of the time we will be wrong and have losing trades. Put another way, that says that, for every 10 trades, we |

|will lose an average of 4 times. Even trading systems or certain trading set-ups with higher rates of returns nearing 80% usually |

|fall back to a realistic 60 to 65% return when actually traded. |

|The reason for this is that human beings trade trading systems. And, when human beings get involved, the rates of returns on most |

|trading systems are lowered. Why? Because humans make trading mistakes and are subject, from time to time, to emotional trading |

|errors. That is the reality and what research indicates concerning good quality trading systems traded by experienced traders. |

|If we are losing 40% of the time, we need to control risk! This is done through implementing stops and controlling position size. |

|We never really know which trades will be profitable. As a result, we have to control risk on every trade regardless of how sure we|

|are about the trade’s outcome. |

|If the number of our winning trades is higher than the number of our losing trades, we can do very well with a 60% trading system |

|win-to-loss ratio. In fact, with risk control, we can sustain multiple losses in a row without devastating our trading account -- |

|and our emotions. |

|By not controlling risk and by using improper trade size, a trader can go broke in no time. Some traders have started and ended |

|their trading careers in just one month! It usually happens like this: They begin trading, get five losses in a row, don’t use |

|proper position size and don’t cut their losses soon enough. After five devastating losses in a row, their trading capital is now |

|too low to continue trading. It can happen that quickly! |

|It is equally important that the trader is comfortable with his or her trading system and that he or she knows it is possible (in |

|fact, inevitable) to have a losing streak of five losses in a row. This is called drawdown. Knowing this eventuality prepares the |

|trader to control his or her risk and not abandon a chosen trading system when a drawdown occurs. It is another important element |

|in “The Trader’s Mindset.” |

|What we are striving for is a balanced growth in the trader’s equity curve over time. |

|So, here’s a list of ingredients for a sound money management plan: |

|Always use stops. |

|Determine your trade size based on your trading account equity, your stop loss price for every trade. |

|Never exceed a loss of 2% on any given trade. |

|Never trade more than 2% on any given sector. |

|Never exceed a total portfolio risk of 6%. |

|Always trade with risk capital, money you can afford to lose. |

|Never trade with borrowed money. |

|Don’t overtrade based on the time frame you have chosen to trade. |

|Trade Size and the 2% Risk Rule |

|The 2% risk rule, along with the 6% portfolio risk rule, has been shown to keep a trader out of trouble, provided his or her |

|trading system can produce 55% or greater win-to-loss ratio, with an average win of at least 1.6 to 1.0 (meaning wins are 60% |

|greater than loses). So, for every dollar you lose when you have a losing trade, your winning trades produce a dollar and sixty |

|cents. |

|Once we take what we’ve said in the previous paragraph as a given, we can proceed to calculating risk. The 2% risk is calculated by|

|knowing your trade entry price and your initial stop loss exit price. The difference between the two gives you a number that, when |

|multiplied by your position size (shares or contracts), will give you your dollar loss if you are stopped out. |

|That dollar loss must be no greater than 2% of the equity in your trading account. This rule has nothing to do with leverage, and, |

|in fact, you can use leverage and still stay within a 2% risk of equity in your trading account. |

|Money Management Example |

|Here’s an example that calculates the dollar amount of 2% risk: |

|Trading Account Equity: $25,000 |

|2% of $25,000 (Trading Account Equity) = $500 |

|(Note: We’re assuming no slippage in this example.) |

|Thus, on any given trade, you should risk no more than $500 net, which includes commission and slippage. |

|Here’s an actual example in the marketplace: |

|MSFT is currently trading at $60.00 per share (at the time of this writing). |

|The round trip commission is $80.00. |

|Our trading system says to go long now at $60.00 per share. Our initial stop loss is at $58.50, and the difference between our |

|entry at $60.00 and our initial stop loss at $58.50 is $1.50 per share. |

|Now, the question is: “How many shares (trade size) can we buy when our risk is $1.50 per share, and our 2% account risk is |

|$500.00?” |

|The answer is: |

|$500.00 minus $80.00 (commissions) = $420.00 |

|$420.00 divided by $1.50 (initial stop loss amount) = 280 shares |

|That means we should buy no more than 280 shares of the stock MSFT to maintain proper risk control and obey the 2% risk rule. |

|If you trade futures contracts or options contracts, you calculate your position size the same way. Note that your trade size may |

|be capped by the margin allowances for futures traders and for stock traders. |

|Note that MSFT (Microsoft) is a company in the technology sector. It is important that, if you want to take another trade while you|

|are still in the Microsoft trade, you must trade a different sector of the market. This same rule applies to options and futures as|

|well. In futures, trade a different commodity. So, basically, using these rules, you will be automatically diversified. |

|Also note that, if your risk in one sector is only 1%, you may take additional trades in that sector until you reach a total of 2%.|

|You should not exceed 6% overall among all the sectors. In other words, the most (or total account portfolio) risk you should take |

|at any given time should not exceed 6%. |

|Remember that the 2% risk must include commissions and, if possible, slippage, if you can determine that. Using this technique will|

|also keep your trade and risk in proportion to your trading account size at all times. |

|If you do not add on to a current position, but your stop moves up along with your trade, you are locking in profits. When you lock|

|in profits with a new trailing stop, your risk on this profitable trade is no longer 2%. Thus, you may now trade another market. |

|So, multiple positions are possible. |

|Trading Capital -- Funding Your Trading Account |

|It is alarming that many traders use either borrowed money or money they really cannot afford to lose or risk. This will usually |

|set the trader up for failure because he or she will be subject to the market’s emotional manipulation (because the trader cares |

|too much about the outcome of each trade). |

|In simpler terms, the trader is nervous about losing the money and, therefore, each stop-out creates more anxiety -- up to the |

|point at which the trader may not want to get out when he or she is supposed to -- and, so, instead of taking the loss, he or she |

|hopes the trade comes back. |

|It takes both responsibility and discipline to accept the trading loss and get out. This is the same type of responsibility and |

|discipline the trader did not have when he or she decided to trade with money that shouldn’t have been traded. Lack of |

|responsibility and discipline in the one instance usually means a similar lack will exhibit itself in the other. |

|If you do not have sufficient risk capital to trade, begin by paper trading to improve your trading skills while you are saving |

|enough risk capital to trade with real money. This way, you will have practiced your trading skills and will do better when the |

|time comes for the real thing. |

|The Psychology behind “Scaling” Out of Trades |

|You can incorporate “scaling” out of trades into your money management game plan; it’s a component of risk control. |

|“Scaling” out of trades is a great technique that can actually convert some losing trades into profitable ones, reduce stress and |

|increase your bottom line! As you may know, I am a big advocate of reducing stress while you’re in a trade. “Scaling” out lets you |

|focus on the trade and not be subject to emotions such as fear and greed, which usually hamper your trading. |

|Scaling out of trades requires that the initial trade size be large enough, so you can reap the benefits of the scaling. The |

|technique is applicable to both long and short positions and all types of markets, such as futures, stocks, indices, options, and |

|so forth. |

|The key here is that the initial position must be large enough to enable you to cover your profitable trade in increments without |

|incurring additional risk from such a large opening position. Remember: We want less stress, not more! |

|Your initial position or trade size should always be within a 2% risk parameter. Therefore, the key now is to be able to initiate a|

|large enough trade size while not risking more than 2% on entering the trade. |

|There are only two ways to do this. One way is to find a market in which you can initiate a large enough trade size with your |

|current trading account size, based on a 2% or less loss if this initial position is stopped out. The other way is to add |

|additional trading capital to your trading account that will allow for a larger position; 2% of a larger account allows for a |

|larger trade size. |

|There is even another way, and that is to use the leverage of options, but you must be familiar with options, their “time value” |

|decay, delta, and so forth. Using options would be considered a specialty or advanced technique, and, if you are not familiar with |

|options, this method could lead to increasing your stress! |

|Here is an example of scaling out of a position and how it can help your trading: |

|This technique works on all time frames from intraday to long-term monthly charts! Let’s choose the E-Minis as an example. |

|In our example, your account size is $25,000, and you choose to risk 2% on this trade. 2% of $25,000 is $500. Your trade entry is |

|1037.75, and your exit is 1036.25, so you can buy approximately 6 contracts and stay within your risk parameters. |

|Now, this means that, if you get stopped out before having a chance to scale out, your loss would only be 2%, which is acceptable |

|from a “risk-of-ruin” standpoint, and, therefore, this potential risk should not create any stress. Note that, if you add risk |

|capital to this trading account, you would be able to increase your initial trade size and still maintain a 2% risk. |

|Let’s say we enter this trade and it starts to become profitable. Here is where scaling out comes in. There are many variations to |

|scaling out, so you will need to paper trade this technique to find which way works best for you. |

|The idea is this: As soon as the trade is profitable enough, cover part of your position and liquidate enough contracts so that, if|

|you are still stopped out, you make a small profit! If the trade becomes even more profitable, you may want to liquate some more |

|contracts to lock in more profit as well. |

|As soon as your trade is profitable enough, liquidate enough contracts so that, even if your original stop loss is triggered, you |

|make a profit. If your initial stop loss is never triggered, you should be able enjoy the rest of the trade and let it go. As long |

|as the trend takes it, you’ll know that, no matter what happens, you should at least make a profit on this trade. Knowing this is a|

|great feeling and will allow you to even have fun trading! |

|There are many variations and themes on scaling out, but this is the basic idea. Also, if you trade only one or two contracts, you |

|really can’t scale out of positions that well. This is another reason why larger trading accounts have an advantage over smaller |

|ones! |

|Some markets are more expensive then others, so the cost of the trade will also determine your trade size. Remember that, in |

|choosing your market, liquidity is important, and you must have sufficient market liquidity as well to execute scaling out of |

|positions in a meaningful way. Poor fills due to poor liquidity can adversely affect our scaling-out technique. |

|The psychology behind scaling out is to reduce stress by quickly locking in a profit, which should also help you stay in trends |

|longer with the remaining positions. |

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