If you have traded any length of time you likely have heard the chant of how important money management is to trading success. Some will even refer to it as the Holy Grail of trading. As often as its virtues are extolled you would think everyone knows all about it and what it really means. Yet, if you ask someone to define money management then typically you will hear more silence than definitions. In light of its stature, it is amazing how many really have no clue as to what it is.
Money management is of course a matter of managing your money, but as applied to trading and investing it includes much more, so the term actually fails to encompass its true meaning. This leads to a great deal of confusion as to what it really is.
Money management includes such things as:
- The maximum percentage of an account put at risk
- The amount of shares, contracts or lots traded at any one time and the addition of new positions or closing of open positions as profits or losses are realized
- Stop placement and other risk control efforts
- Profit taking
- Strategies for minimizing losses
- Hedging
- Portfolio diversification
- Strategies for determining profit/risk ratio of specific trades
This list is just a sampling of what money management covers, but each of these is well worth defining in more detail.
The maximum percentage to place at risk is what is commonly referred to as your total risk. Most experts recommend only 2% to 5%, with some even recommending as little as ½% . This is a personal choice, but the more you risk at any particular time then the greater the losses you will face if the trade or investment fairs badly. The other side of the coin can also be argued, the less you risk then the less you will make. The truth really depends on the type of risk you take because some trades have greater risk than others. The percentage we are talking about here deals with what you are risking at any one particular time and typically does not include transaction costs or margin requirements as used with futures trades. It is based on what you are actually at risk of losing and depends on such factors as where you are place your stops and other similar loss prevention strategies.
For example, if you have a $100,000.00 account and you place a trade that requires you to risk losing $2,000.00 then your risk is 2%. If you are only allowing a total of 2% risk and lose that $2,000.00 then you have a problem since you can no longer place a trade, the percentage is already used up. An adjustment must then be made and a 2% risk would reflect the new total account, now at $98,000.00, which allows a risk of $1,960.00.
The amount to be traded is a determination of how many shares, contracts or lots used in a trade at any given time and can vary depending on different criteria. There are numerous strategies in how this can be used to a traders advantage. For example, if your goal is to trade 2 contracts of the S&P e-mini then you might initially trade 4 contracts and when a 1/2 of a point in profit is achieved then exit out of two of those contracts. The profit from these two would typically pay for the entire trade. There is still a risk of a greater loss, but typically obtaining a ½ a point is not difficult unless you are trading against a very strong trend. Another strategy involves adding to an order as it reaches certain profit levels, thereby allowing profits to fund a greater potential return. A entirely different strategy starts with a large order, but will have a trader exiting out partially at certain profit level intervals until the entire order is eventually closed. These are but a few examples of the many that are available, but they afford an opportunity to enhance the trading experience and enable a trader to accomplish much more than with a simple enter and exit strategy.
Stop limits provide some protection against a catastrophic loss and no trade should be made without them. Most traders find setting stops a real challenge. If you set them too close then you will repeatedly be out of a trade at a loss, even when a trade eventually moves favorably. Set them too wide and the losses can be quite large. As challenging as stops are, this is one aspect of money management that you cannot avoid even if you are a long term investor, as recent stock declines highlight. It is always much easier to make up for a smaller loss than it is a large one, particularly if such loss makes any further investing or trading impossible. Stops are frequently placed just beyond prior lows or highs or some other expected limitation of the market. Whatever method you use to establish your limit, make sure you use it.
Profit taking is intentionally taking a profit when the market meets certain criteria. Some view the exit of a trade as more important than the entry and it is easy to agree with this when experience teaches that even a bad trade entry can turn out well with a good exit while a good trade entry can end up disastrous with a poor exit. Some strategies deploy an exit when a certain percentage of profit is reached. Others take profits when certain criteria such as prior highs or lows are reached. Still others base this decision on changes in momentum. The variable choices here are considerable, but the idea is the same; take profits at a specified point before the market takes the profit away. Although locking in profits will reduce further profits if the market continues to move in a favorable direction, the issue is that profits are often lost simply because a trader overstayed and the market retraced. This strategy insures that a profit is actually made during a favorable trade.
Strategies to minimize losses are designed to reduce the impact of a loss when they do occur. Some losses are to be expected, it is simply a part of doing business as a trader or investor just as shoplifting is a loss that practically every retail store has to endure. An example of such a strategy is the use of options as a hedging instrument. Another strategy is by timing an exit. For example, if a stop is violated and the market appears to be consolidating then an exit would not be taken immediately. Instead, an allowance is made for the market to return to a more favorable position and then exited so as to reduce or eliminate the loss. The point of exit would be based on an expected point of retracement that would be reasonable. Although handling an exit this way potentially allows for greater losses and the market may never return to a profitable or break-even level, this strategy can dramatically reduced a loss if handled properly.
Hedging is what the commodity markets are really all about. While farmers and producers use hedging in a variety of ways, the reason is basically the same: as insurance to protect the value of what they have or will have to sell. If corn is currently at a very good price for a farmer to sell at, but his crops are not due to be ready for harvest for another six months then he can hedge those crops against the current price and insure from any decline in the future price. Although as a trader or investor we may not have a product or crop to sell we can still use hedging to our advantage in a number of ways. Use of options, establishing inter-market spreads and intra-market spreads, just to list a few.
Portfolio diversification is a term well known by many investors. Very simply, you diversify your trades and investments across a broad spectrum of markets thereby protecting them from being impacted all at once by the same factors. While it may not fully protect your investments from major stock market declines as we have had recently, doing so will protect you from typical panics which are market specific. An example would be if you had owned only NASDAQ stocks in 2000 when the technology boom ended. Although the Dow Jones index suffered as well, the losses were not as extensive and it recouped much more than its prior value by the year 2007. The NASDAQ never even came close to doing so.
Strategies for determining profit/risk. Every trade has risk whether you are trading junk bonds or T-bonds, Goldman Sachs or Gold, UPS or the US dollar. Not all risk is the same, nor is the profit potential. Would you be willing to risk $100.00 to make just $1.00? What if you were risking $1.00 to make $100.00? If you had to chose between the two and the odds of success is the same, which one would you take? The answer should be obvious, but as extreme as this illustration may seem to be it is amazing how often individuals will actually choose to risk $100.00 for just $1.00 profit. Do you really know how much you are risking and for what? This is why it is of great value to determine the profit against the risk in any trade.
While this summary is only a glimpse of what the term money management actually includes, it can serve as a valuable guideline in your endeavor to master it. Whether money management is the Holy Grail of trading or not, one thing is for sure it is an essential part of any successful trading or investing. Learn to love it and make it an intricate part of your trading. By doing so, you will find that you also need money management in another way, managing all the money you have accumulated in your bank account.