Proper money management is one of the key pillars of any successful trader. It’s said that even the best technical trading system, without the help of a sound management scheme for both positions and money won’t take you very far. Some even say that a mediocre technical system coupled with a good money management scheme has better odds. Well, since you’re already solving the first part of the equation by learning our Professional Trading Strategies (PTS) concepts, it’s about time that you spend some important time designing a sound money management system.
Before we talk about how to design diverse types of management systems, we need to define what are they and why they are important to the active trader. A money management system is a set of rules and parameters that allow you to properly manage risk and reward. If we understand trading as an activity where you find certain events which under certain circumstances tend to more often than not produce a certain “suggested” move, then we need to also understand that some of these events will fail, while some will actually move in the desired direction. We don’t know which events out of the whole universe of “events” we trade will produce the losses, and which the gains. Since we can’t determine which events will be the losers, we need to consider each of these events as potentially a losing event. Thus, each event should have a monetary risk level that is similar to the risk level of all the other trades we take. It wouldn’t make much sense to take an IBM position with a risk of $1000 and a DELL position with a $200 risk. If we did that, then the weight of the IBM trade would be 5 times that of the DELL trade. A trader doing this kind of thing could end up having more winning trades than losing trades and still lose money. So, we need to devise systems that will allow us to determine and manage the risk taken on each of these events, while also establishing rules to manage the potential “rewards” obtained in the successful events. We’ll begin by discussing the risk factor.
A proper money management system, irrespective to the sophistication level it displays, should first of all focus on risk management. No trader will likely last in this business if he doesn’t take care of his capital. So, an exhaustive system for controlling risk is paramount. There are countless ways to do this, but it all starts with the placement of a stop. If you’re reading this you probably don’t need to be convinced as to the importance of having a stop, right? The fact of the matter is that there are many ways to place a stop. Some people place stops based on a predetermined equity they’re willing to lose. Thus, they’ll use a certain percentage level of their account for each position. While this is better than not having stops, it is an extremely random stop which will be hit at the markets whim. Some others place stops based on average volatility (an example of this would be using Bollinger Bands) to avoid getting stopped out when higher volatility produces higher “noise” in the price development of a security. At Live Traders we use technical stops based on price levels of support and resistance, as we believe it’s the more accurate placement. But the placement of a stop in itself isn’t nearly enough to even scratch the surface of a proper management system. As in the example outlined in the first paragraph, you can have stops and still bleed your account to death. When talking about stops, at Live Traders we advocate the school of thought that establishes stops which should be smaller than the projected targets (2 to 1 or 3 to 1 Risk to Reward Ratio).
After you determine the style of stops to be used, you need to establish several parameters in your trading plan which will help you to properly manage your account.
