MONEY MANGEMENT 101. MONEY MANAGEMENT 101 If I could say only ONE THING about Money Management it is...

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MONEY MANGEMENT 101

Transcript of MONEY MANGEMENT 101. MONEY MANAGEMENT 101 If I could say only ONE THING about Money Management it is...

MONEY MANGEMENT 101

MONEY MANAGEMENT 101

If I could say only ONE THING about Money Management it is that

• You will most probably NEVER get rich without it or at best

• You will probably lose what temporary riches you may have accidentally acquired without it.

MONEY MANAGEMENT 101

• IGNORING Money management in trading is like running a manufacturing business without studying automation.

• Leverage and the Compounding -Without it you will most likely fail

• It is said that new traders go broke taking large losses and that professional traders go broke taking small profits.

Money mgmt + Psychology• Whatever you do make sure you do not attempt to employ

good money management without understanding trading psychology.

• There is nothing more important in the trading process than the decision maker. You are the decision maker.

• Every thought you have while trading and making trading decisions is part of your personal psychology. No weapon can be so powerful for or against you than your own emotional state.

• No experience in trading can have such a dramatic effect on your emotional state as when too large of a position size is either going into loss or into profit.

• If you have on too large a position size and it goes into profit you will be encouraged to do repeat the mistake you made in position sizing.

• Anything that encourages even one instance of bad trading behavior is your enemy.

• If you have on too large a position size and it goes against you that can cause an unfortunate and even devastating blow to your confidence. It can ruin the rest of your trading day and spoil your judgement or it can ruin your whole year.

• Generally a large loss is less dangerous than a large win. A large win achieved by breaking your trading rules and employing too high of leverage can set you up like a chump and then take you for ten times as much a bit later. Whereas a large loss may take the wind out of your sail and possibly even force you to stop trading. That may actually be healthier and safer for your account.

Money mgmt + Psychology

Why Money Management? 1. Money Management is how you Minimize Risk and

Maximize Profits.

- Take a system that when trading one contract makes 5,000 profit in a year with a 10,000.00 account. Let's say it's a day trading system and the system signals 400 trades in a year.

- When you apply compounding to that exact same trading system you could easily turn that same 10,000 account with the 5,000 in profits into 16,000 profits from that 10,000 account. Instead of 50 percent profit you now have 160 percent profit. This is a realistic example of what the compounding side of money management can do for you.

Why Money Management?

2. Money Management is also about risk control.

Risk is what you may lose in trading. When you lose money you want to minimize the impact of those losses on your trading account so that the hole you need to dig yourself out is smaller than it would otherwise have been.

Good risk control increases the number of times you can be wrong without having disastrous effects on your trading capital. This allows you to stay in the game longer with less psychological pain to hurt your trading decisions.

Why Money Management?

3. Money Management is also about leverage. The only two things that can make you a fortune in life are leverage and compounding.

Properly combined these two forces tend towards explosive profits. Improperly applied these two tend towards implosive losses that destroy trading accounts, families, and careers.

Why Money Management?

4. Money Management is the key to profit in trading. Most professional traders who achieve Market Wizards kind of astronomical returns do so with their money management system more so than their portfolio of trading systems.

In fact Richard Dennis, one of the most successful system traders ever, claimed that a trading system was not really a trading system until the money management rules were in place.

Compounding

• Compounding is how you will make your money during equity run ups or winning streaks in this game.

• Risk control is how you will retain your account equity during drawdowns or losing streaks.

• Money management is about combining a strategy to maximize equity gains and minimize losses in order to obtain a growth curve

Compounding• By far the most profitable money management scheme is going to be

the Most Agressive amount you can risk without wiping out your account.

• The larger the drawdowns you can stomach the more proft you can make.

• However most people misjudge this by choosing a level of risk that they presumptuously think they can stomach. Then they trade that risk level until they find themselves in the middle of a larger drawdown than they expected.

• Then they bail at the critical moment just before the market turns and would have given them back all the losses with huge gains on top of that. However they bailed and are left only with their losses.

• Therefore a more agressive money management scheme is often the fastest road to poverty and a less agressive one is more profitable because of the psychology involved.

Compounding

• Again this illustrates how critically related Money Management and Trading Psychology are.

• If you don't have money management that is suited to your psychology you'll fail and leverage will take you down. Either through too small of profits or too large of losses or both.

Leverage

• This is the use of credit. If your account is 100k and you never risk more than 100k you don't need any leverage to trade.

• The moment you have a greater position size than your account size, you are using leverage. If you have a 200k position size and your account is 100k your leverage is 2:1. Simple.

• Think in these terms and whenever you have a trading system or dealing station that uses units and leverage settings that seem confusing -- just translate everything back to this simple understanding.

Leverage

• Another way to describe leverage is that it means using a small amount of money to control a larger amount.

• Like mortgaging a house. You put down 20 percent of your own cash and the bank loans you the rest. If the house goes up in 30 percent you benefit from 30 percent of the entire value of the property even though you only have 20 percent of your own capital into it.

Leverage Advantages

1. Permits a trader to expose his account to much higher profits than without it.

2. Permits a trader to use small amounts of money to make larger amounts.

3. Fosters a trading environment where you must learn greater respect and discipline than without it.

4. Combined with a compounding scheme that maintains control of risk and is applied with discipline and consistency -- it is the secret to large profits.

Leverage Disadvantages

1. Permits a trader to expose his account to much higher losses than without it.

2. Permits a trader to use small amounts of money to lose larger amounts.

3. Many traders are fooled into abusing it.

4. Combined with a compounding scheme such as pyramiding it is the secret to disastrous failure.

MONEY MANAGEMENT 101

• WORST MISTAKE – IS NOT TO USE IT!

• NO clearly defined money management system in place = NO trading system

• Because your trading system, in order to be complete, must define your Correct Risk, Position Size, and Compounding Method.

MONEY MANAGEMENT

Most Traders do a similar thing with respect to money management. They look for trades, watch an existing trade move pip by pip and stare at it, look blankly at charts trying to see patterns, anything but noting down their

• Account equity, • Multiplying it by their risk percentage, • Determining the value of a single pip on the crosses,• Dividing their dollars to risk by the value of a single

contract and • Determining the number of contracts to trade that pair

for several stop sizes so they have a handy reference to verify the calculation they must do for each and every trade where their stop size is determined at or near the time of entry.

MONEY MANAGEMENT

Then when a trade comes along they do not know the

• Exact Risk• Exact Position Size

So they make a quick judgement and put the position on and find out it is too much or too little risk or they just don't care. Regardless this is where a lot of money management mistakes are made.

Lack of Preparation

MONEY MANAGEMENT

• Not taking the time to understand COMPOUNDING is another BIG mistake.

• Think about your current strategy for position sizing. Many people who are just learning to trade risk 3% per trade or more.

MONEY MANAGEMENT

• You begin trading and risk 3 percent on a trade. You make a few mistakes and begin to drawdown and after only 20 trades you have LOST 1/2 your account.

• Now lower the risk to 2 percent and you can trade 30 trades before losing 1/2 your account.

• But drop it to 1 percent and you can handle 64 trades before losing 1/2 your account.

MONEY MANAGEMENT

• Losing money in trading is so Quick and Easy and it is not really fun at all.

• We immediately compare the loss to what we could have used the money for alternatively

MONEY MANAGEMENT

• When we learn to trade a new system – we are demo trading, we tend to trade as though we are much further along.

• However to make good use of demo trading or trading real money we should be trading exactly the same way as if it was real money so that we make that transition more easily.

MONEY MANAGEMENT

• Or if we are trading a very small account that could never support us with an income we still be trading it as though it was a very large account so that we learn all the same habits when we are trading larger amounts.

MONEY MANAGEMENT

Example: we are now demo trading a 10k account and are risking 3 percent. We have the account size right and we are risking 3 percent per trade. First loss is 300.00. Second loss is 291 and so on. In only three trades we have lost close to 1000.00. Ok it was only 873.00 but we tend to round these things down as we are losing money. Damn! Almost 1000.00 lost and it is my first evening trading. Ouch! I could have done a lot with that money and got 1000 times more enjoyment from it than I got from those three trades.

MONEY MANAGEMENT

• This sort of thing gets our focus on how much we are losing rather than on trading the system.

• We are not looking at losses as they are part of our system we are looking at the losses and how they affect us.

• This completely screws up our ability to trade rationally because we are defensive in our trading and too focussed on not losing rather than on winning.

• The more we think about loss the more we tend to activate that part of our judgement that will help us lose. This process also debilitates the part of our judgement that helps us win.

MONEY MANAGEMENT

• Discipline has to do with doing things in a way that makes sense to us on as many levels as possible

• so that we are more inclined to follow our system instead of becoming emotionally distracted by the impact of excessive risk.

Martingale System

• Martingale: this famous type of system employs increasing leverage as equity decreases. The most form of Martingale system also known as a "double or nothing" system.

• If you bet a dollar and lose then you double your bet to two dollars. If you lose you double your bet to four dollars. If you lose that you double your bet to 8 dollars. If you win the 8 dollar bet your winnings are 16.00 and your losses are 7.00 so you have a profit of 9.00. That is Martingale at its simplest. If you want to read about this more just do a search on "Martingale bet" and you'll find lots of interesting reading.

Anti-Martingale System

• Anti-Martingale: This is a system that is the opposite of a Martingale. With each losing trade the bet size will be smaller since equity has declined.

• All money management systems can either be classifed as Martingale or Anti-Martingale or "fixed bet" -- ("fixed bet" never varys the position size).

Martingale and Anti-Martingale

• Martingale systems work great if you have unlimited funds. You cannot possibly lose with a Martingale system if you take your profits on a win and quit there. Each time you double your bet you will always be able to pay your losses and post a tidy profit. However many people have gone broke with this approach and so have many traders. Nobody has unlimited staying power because Nobody has Unlimited Resources.

Trading with NO system- NO Fixed Risk

- NO Position Sizing- NO COMPOUNDING

Trading with NO system- NO Fixed Risk

- FIXED POSTION SIZING- NO COMPOUNDING

A Trading System in place..

• Now if we use a 3 percent %R system that treats all trades with equal risk.

• Notice especially the contrast between the previous two examples. The %R system never goes beyond 3 percent risk and all trades are treated as having an equal probablity of success or failure.

• During drawdowns the position size continues to decrease with relative losses getting smaller and as soon as the system has a winner the next trade is treated with the same probabilty as any other trade. Bottom line is that no trades are treated as having less or greater probability.

• The profits speak for themselves.

IMPLEMENTATION

Implementation

1. Decide on a constant risk percentage per trade and then calculate the position size you'll need. For newbies I'd suggest no more than 1 percent per trade. Regardless once you decide on a risk percentage then don't vary the percentage.

• Suppose your account size is 5000.00 and you have a micro mini account. That means if your risk is .5 percent then your risk is 25.00 per trade regardless of stop placement.

[.005 * 5000.00 = 25.00]

Implementation

2. Calculate the position size for every trade based on closed equity. If you don't know what that means -- it means that if you have open trades you don't count any profits or losses that the trades currently are posting because the trades have not been exited yet. Since they have not been posted you have no idea whether they'll win or lose. Therefore equity calculations based on those trades would be unreliable since the outcome of them is unknown.

- You calculate your position size as follows: If your account size - 5715.00 and you are risking .5 percent then your risk in dollars is 28.05 or rounded = 28.00.

Implementation

3. Calculate your stop size based on your trading system. Your stop size should have nothing to do with your money management. If you are trading a pin bar and the pin is 72 pips long then your risk is going to be about 80 pips on that trade (depending on how far above/below your pin bar you want to place your stop)

Implementation

• lets say your stop size is 33 pips on the trade you are calculating and your account is 5715. If you are this new to trading you should only be trading the majors to keep things simple. Your risk is 28.00 and your stop size is 33 pips.

• We know that a 33 pip stop at 10 cents a pip is a risk of 3.30. In order to find out how many 3.30 cent 1000.00 (micro) lots you can trade you must divide 28.00 (our total risk) by 3.30 which = 8.5. If you have an account that allows you to trade fractions of a mini lot then you can enter .85 of a mini -- but if you can only trade in round micro lots then 8 micro lots is the number you can trade while risking .5 percent of your account.

Implementation

4. Place the trade, set your stop, and let the trade do its work. If you make an error on position size immediately adjust your position size if your dealing station allows it OR close the trade with whatever loss you incur and chalk up that up to disciplinary action to remind you there is a penalty for mistakes.

If your position size was much too small then in most cases you can just open another position with the missing amount.

Implementation

5. Just keep trading the same percentage of your equity on each trade.

If your account increases so will your position size.

If your account shrinks your position size will shrink too.

That is exactly what you want from a money management system.

PRACTICE TIME