I n my opinion, money management is the most significant part of any trading system. Many professionals, and most amateurs, do not understand how important it is. In fact, I recently attended a seminar for stock brokers that detailed a particular method of investing that they could use to help their clients.
While the seminar as a whole was terrific, the topic of money management, as I’ve defined it here, was not even covered. One speaker did talk about money management, but I could not fit what he was talking about into this discussion at all. At the end of ,his talk, I asked him, “What do you mean by money management?”
His response was, “That’s a very good question. I think it’s how one makes trading decisions.” Since money management is the difference between poor performance and great performance - the difference between going broke and being a successful professional - it’s important that I define it right now. Please take note.
The concept is critical because the question of “how much” determines your loss potential and your profit potential. In addition, you need to spread your opportunity around into a number of different investments or products. Equalizing your exposure over the various trades or investments in your portfolio gives each one an equal chance of making you money.
I was intrigued when I read Jack Schwager’s Market Wizards in which he interviews some of the world’s top traders and investors. Practically all of them talked about the importance of money management.
Here are a few sample quotes:
“Risk management is the most important thing to be well understood. Undertrade, undertrade, undertrade is my second piece of advice. Whatever you think your position ought to be, cut it at least in half” - Bruce Kovner
“Never risk more than 1% of your total equity in any one trade. By risking I %, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical. ” - Lamy Hite
“You have to minimize your losses and tv to preserve capital for those very few instances where you can make a lot in a very short period of time. what you can’t afford to do is throw away your capital on suboptimal trades. ” - Richard Dennis
Professional gamblers play low expectancy, or even negative expectancy, games. They simply use skill and/or knowledge to get a slight edge. These people understand very clearly that money management is the key to their success. Money management for gamblers tends to fall into two types of systems - martingale and antimartingale systems.
Martingale systems increase winnings during a losing streak. For example, suppose you were playing red and black at the roulette wheel. Here you are paid a dollar for every dollar you risk, but your odds of winning are less than 50% on each trial. However, with the martingale system you think you have a chance of making money through money management.
The assumption is that after a string of losses you will eventually win. And the assumption is true - you will win eventually. Consequently, you start with a bet of one dollar and double the bet after every loss. When the ball falls on the color you bet, you will make a dollar frbm the entire sequence of wagers.
The logic is sound. Eventually, you will win and make a dollar. But two factors work against you when you use a martingale system. First, long losing streaks are possible, especially since the odds are less than 50% in your favor.
For example, one is likely to have a streak of 10 losses in a row in a 1,000 trials. In fact, a streak of 15 or 16 losses in a row is quite probable. By the time you have reached ten in a row, you would be betting $2,048 in order to come out a dollar ahead. If you lose on the eleventh throw, you would have lost $4,095. Your reward to- risk ratio is now 1 to 4095.
Second, the casinos place betting limits. At a table where the minimum bet was a dollar, they would never allow you to bet much over $50 or $100. As a result, martingale betting systems, where you risk more when you lose, just do not work.
Antimartingale systems, where you increase your risk when you win, do work. Smart gamblers know to increase their bets, within certain limits, when they are winning. And the same is true for trading
or investing. Money management systems that work call for you to increase your position size when you make money. That holds for gambling and for trading and for investing.
The purpose of money management is to tell you how many units (shares or contracts) you are going to put on, given the size of your account. For example, a money management decision might be that you don’t have enough money to put on any positions because the risk is too big. It allows you to determine your reward and risk characteristics by determining how many units you risk on a given trade and in each trade in a portfolio.
It also helps you equalize your trade exposure in the elements in your portfolio. Some people believe that they are “managing their money” by having a “money management stop.” Such a stop would be one in which you get out of your position when you lose a predetermined amount of money - say $1000.
However, this kind of stop does not tell you “‘how much” or ‘how many,” so it really has nothing to do with money management. Controlling risk by determining the amount of loss if you are stopped out is not the same as controlling risk through a money management model that determines the size of your position.
There are numerous money management strategies that you can use. In the remainder of this update, you’ll learn different money management strategies that work well. Some are probably much more suited to your style of trading or investing than others. Some work best with stock accounts, while others are designed for a futures account.
All of them are anti-martingale strategies in that your position size goes up as your account size grows. The material is somewhat complex. However, I’ve avoided the use of difficult mathematical expressions and given clear examples of each strategy. As a result, you simply need to read the material carefully and go over it until you understand it.
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