Series: What’s in a Trading Strategy – Money Management
This is the second is a series about trading strategies. The first posting is located here.
Money management is probably one of the most important components of a trading strategy and the most misused and misunderstood. When I first started trading in 2002 I was taught that your trade shouldn’t exceed some percentage of your trading account. I still hear this mantra from clients today and it’s time to move the concept of money management into the 21st century.
Let’s put this into perspective. Let’s say your going to buy a car. When do you consider the price of the car? Before you begin shopping of after you’ve picked out the color? Do you let the salesman and the sales process dictate your purchase or do you control how much you are going to spend?
Most prudent shoppers are going to have an idea before they begin shopping of approximately how much they can spend. We may not have complete control over what we are are purchasing, given inventory availability, but we can control how much we’re willing to spend.
There are a lot of reasons to create and maintain this control over your spending. For the sake of this discussion, the main reason is to know when you’ve reached your spending limit. The ability to say “no that’s enough” is incredibly important. To be at choice over what and how much you are spending.
Sadly, when it comes to trading, we often leave this common sense thinking at the door of our trading offices. True money management should be about controlling how much you are willing to put in the market during any individual trading session. Knowing when to say “that’s enough” is what will keep you trading for tomorrow.
The way to achieve this is to create a distribution pool from your trading account to finance the current trading day’s activity. Hedge funds do this on a much larger scale but the basic principle is the same. Here’s how it works.
Let’s say you have $10,000 and you’ve determined that you’re willing to risk 10%. (The discussion about how much to risk is for a different posting.) That gives you $1,000 for today’s trading activity. All your trades will be funded out of this $1,000. When you’ve gone through that money, you are done trading for the day.
This distribution pool of funds becomes the gauge by which you measure today’s trading activity. If you have made a series of loosing trades and find you are down $400, or 40% of your allotted funds, use that as an indicator that perhaps you are not in the right frame of mind to be making trades today. Perhaps you need to change your point of view for a moment. Get a cup of coffee or go for a short walk to clear the mind and change your perspective.
If the opposite is true, and you find that you are up 40% on the day, that could be an indication that the day is going well and the need to take every tradable opportunity is not necessary. More trading does not necessarily lead to more money, but it does lead to greater risk.
In the end, trading is about our decisions and how we feel about them. Having rules is essential, but they are not the entire story. To understand that the judgment calls we make in the market has a greater effect on our trading then mere rules is the key to trading success.
If you would like a copy of Money Management – Debunking Common Wisdom feel free to send me a email and I’ll be happy to send it to you.