In the first installment of this article, we discussed the importance of having a well-structured business plan for our trading activity, no matter which goals we were pursuing. We also discussed the need to establish goals, which in turn would determine the procedures and parameters for Money Management and Strategies. Today we’ll analyze the second “chapter” in any trading plan: Money Management.
Any technical trading system, no matter if it’s called The Live Traders Method or otherwise, will not produce consistently profitable results in the long run, unless it’s coupled with a systematic approach to money management. Money management is the administrative portion of the business plan. If we start with the notion that trading is an activity where we look for events that provide higher odds of producing a desired outcome, and then we establish a strategy to trade such events looking to maximize the positive results and minimize the negative results, then we need to understand that the way in which we administer each of those events will directly affect our final performance as traders. We also need to acknowledge that we can’t predict which of those events will produce the positive results, thus we need to administer them in such a way that none of them will pose a significantly greater risk than any other. To do this, we need to first establish the parameters with which our activity will be measured.
Initially, we have to determine our “trading goals”. These will be the ones that will allow us to measure our progress and performance on an ongoing basis. Since we’re talking about swing trading, those goals should be established in a timeframe that is relevant to the style. We need to determine our batting average (# of Winners divided by the total # of trades), and a Win/Loss Ratio (Simplified Sharpe = Avg. money made on winners divided by avg. money lost on losers). These two figures will help us when measuring our performance. Then we need to establish our parameters for losses, profit targets and such. As I just mentioned, these should be in a timeframe relevant to swing trading. Since swings aren’t opened and closed on the same day (for the most part), we can’t have these figures on a daily basis. Weekly or monthly are better timeframes for this.
We need to determine our profit target for any given period, plus the maximum loss per account, per month and then per trade. The first will be used later to plan our course of action in case of a profitable month. The maximum loss per account will help as a circuit breaker in case things don’t work out as planned in our overall activity (Many traders wait until their accounts are down to the last dollar before admitting this. If this level is reached, stop trading and look for qualified help or coaching). The maximum loss per month is important because we need a threshold where we can stop the bleeding for the month, avoiding a snowball effect that will lead to greater losses as the trader looks for a “comeback”. Every trader, regardless of his ability, will have profitable and losing periods. For a swing trader, most of the money in a year is made in 3 or 4 months of the year. He might have 1 or 2 losing months. His job is to make sure that those 2 losing months don’t kill his performance for the year. The maximum loss per trade will help to determine the maximum amount of shares traded.
Also of importance for the swing trader is establishing a maximum allocation of funds for each position. Gaps come with the territory, and we don’t want to have 80% of our swing account in the one position that gaps against us 20%. A maximum of 20% of our account in any position is a widely recommended number, but you need to come up with your own optimum one.
Obviously, we also need to deal with the winning trades. If we have a target for the month, will we stop trading when this target is reached? Or will we establish a set of rules in order to protect most of that profit, while at the same time continuing to trade? Since I believe that the 3 to 4 good months of the year are the ones where we should strive to maximize the profits (the losing months are guaranteed, just like death and taxes), I’m inclined to do the latter. Maybe a “trailing stop” of 80% of your profits, where you can only assume new risks (positions) that in total won’t exceed 20% of your hard-gained profits would be an idea. Again, the levels are just for example purposes, you need to come up with your own.
Creating a set of rules based on these basic premises will most likely help you as a trader to maximize the potential of your trading plan. But for this, we need to come up with the strategies which will produce the “positive” and “negative” results we need to manage. That will be the subject of the third part of this article.
