Principles Of Money Management – Guest Post
Money management in financial trading refers to the measures that a trader takes in order to preserve capital and to be able to stay in the market longer. Money management involves a whole range of psychological and statistical factors, as well as some common sense to execute.
There are several issues to consider when talking about money management. These are summed up by these questions:
- What is the trading account size relative to the asset being traded?
- Appropriate trade sizing: how much money should a trader invest in each trade?
- What is the trade focus: long term or short term trading?
- What is the approach of the trader to a string of losses?
- What is the approach of the trader to a winning streak?
- At what point must a trader decide that a losing trade is beyond redemption?
- How are all aspects of the trading process tested?
- How does the trader handle market volatility?
What is the size of the trading account relative to the asset being traded?
The CFTC set different leverage requirements for options trading and currency trading. If you are to trade currencies with a US broker, you need to put down $2000 for every Standard Lot trade contract worth ($100,000). If the trader has $10,000 in his account, that is equivalent to 20% of account size on a single trade, and that is way beyond the maximum recommended level of 5%. In order to conform to proper money management, the trader must jettison any plans of trading standard lot contracts and restrict himself to a maximum trade exposure of 5 mini-lots. Of course, there is no rule that says that trader cannot trade lesser amounts or fund his account to handle larger trades. This takes us to the next point.
Appropriate Trade Sizing
Once you know how much capital you have in your account, it becomes easier to apportion the appropriate sizes to your trades. Another factor that must be considered is the positioning of the stop loss and the expected reward for the trade when compared with the risk. Taking a cue from our illustration above, a trader has no business trading standard lots under the CFTC leverage regulations with a $10,000 account.
Is the trader trading for the short term or long term?
Scalpers and short term traders make their money from picking off small profits one at a time. For this group of traders, timing is everything. The fill of the trade can also impact on how much this group of traders can make. Short and ultra-short term traders are more prone to using large positions so as to profit from shorter moves in the market. If a trader’s scalping technique is damaging the account when losses occur, it may be time to change the trading approach to a longer-term view.
What is the trader’s response to a losing or winning streak?
The typical response is for a trader on a winning streak to bump up his stakes with more risk, and to try to recover lost capital immediately whenever there is a trade loss. Either way, proper money management is not being carried out. The trader needs to calculate his 5% maximum trade sizing to match his new account balance, whether he is winning or losing. If he is losing, he needs to take time off to re-evaluate his trading style, technique and strategies to correct the deficiencies.
At what point should a trader cut his losses and move on?
A careful re-examination of a losing position will show when to quit. Under normal circumstances, if the stop loss is correctly set, it should take care of this. But in this situation, the trader either has shifted his stop loss several times, or did not set one at all. One way of knowing what to do is to look at the price action and check to see if there are areas of support and resistance where prices can take a breather. If you are in no man’s land (at a point which is midway between support and resistance) it may be best to simply end the trade immediately and focus on working towards a phased recovery.
Testing Aspects of the Trading Process
It has always been conventionally held that a demo account is the trader’s best bet when doing trade simulation. However, while it is advocated to use demo accounts to learn the basics, there are flaws with demo accounts. For instance, why would a trader open a $100,000 practice account when he probably will start trading with $1,000? The trading conditions are not the same and the approach the trader will have to the testing process will also not be the same. A very good way of testing aspects of the trading process is to open a live micro-account and to fund it with $100. This way, live trading conditions have been simulated, and the trader’s approach to risk management will be thoroughly challenged. The experience gained from here is immeasurable.
Handling Market Volatility
Market volatility presents challenges to traders. Intense volatility leads to slippages which blows out stop loss positions and lead to compounded losses. A trader needs to know when to take advantage of market volatility or when to completely stay out of the market.
When these issues have been addressed, you can say that you are on your way to effective money management.
Guest post by Joaquin Monfort who is a financial analyst and currently works as a technical and fundamental analyst for Forex4you.com.