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Chapter 7: MONEY MANAGEMENT

I often say in my newsletter (TTT) that Money Management (MM) is far more important than analysis. But I have never given a practical example of how this should work. This chapter is designed to remedy this omission.

It is easy to demonstrate that MM is far more important than analysis. A total lack of MM would mean risking everything on any one trade. You might have the best analysis system in the world and get 99 straight trades right but that 100th trade would wipe you out. On the other hand you might have the worst analysis system in the world. If so a proper MM system will quickly reveal this fact which at the same time minimizing the risk to your capital. So if you get 10 straight trades wrong you still only lose 10 per cent of your capital! It is therefore immediately clear which is the more important. MM is what makes the analysis/system work not the other way around.

The conclusion from this is that it is not entry which is that important – it is exit. This is clearly so, because exit determines your overall risk, your overall profit and your overall control. Now this is quite a controversial statement. If entry is not so important why do all traders spend so much time on it. The answer is because they are misguided. Clearly entry is also important, but not as important as the other factors in trading, in particular MM and Risk Control (RC). To put this in a nutshell: your entry cannot wipe you out – but the way you exit can. Your entry does not make you a profit – the way you exit can.

Using Money Management

So how do you use MM practically? For this I will use an illustration concerning one of my trading services. This sets out the MM rules behind this. This is universally applicable to any trading approach not merely to this system. The essential factor behind any winning approach is that it gives you an “edge.” Without an edge it is impossible to win – if anybody doubts this please e-mail me to discuss it. I consider that my methodology gives me an edge of around 60–70 per cent. This has to be related to a random process which could be gauged at 50 per cent. The figure of 50 per cent is not totally accurate as it ignores the costs of trading, but we will over discount for this factor by assuming that my approach will yield a success rate of 55 per cent. It now comes to apply an MM system to this. Let us assume that a trader has £10,000 he is prepared to lose. As a general rule a 20 per cent loss is considered the time to get out – so we are assuming that the trader has capital of £50,000 of which he is prepared to lose £10,000. With £10,000 our MM rule is that we are not prepared to lose more than 10 per cent per trade (i.e. £1000) and this equates to 100 points on a single FTSE futures contract, or 50 points on two contracts. If we adopt this approach it means we would have to suffer 10 trades in a row to be wiped out of the market – i.e. we would lose our £10,000 (20 per cent of our total trading capital of £50,000). So we then take our expected success rate of 55 per cent and see what the odds are of making 10 successive losing trades. The odds on this are 45 per cent (the failure rate being 100 per cent less 55 per cent) to the power of 10. This comes down to 0.035 per cent – i.e. 3.5 times out of 10 000 trades. The 45 per cent failure rate also shows us that we have a 1 in 10 chance of making three losses in a row, a four out of 100 chance of four losses in a row, and a 2 out of 100 chance of five losses in a row. These odds make sense and we can see how this approach can be monitored to ensure that the original assumptions are correct. If so, it is also easy to go further and to develop confidence in the approach. Now to some of you a 100 point stop may seem a little high, but there are ways to mitigate this exposure and at less risk. You will also note how applying 10 per cent to one fifth of the capital equates to 2 per cent of all of the capital. It is my view that any one trade should not incur risk of more than 2 per cent.

Position size

The above sets out one way of approaching Money Management. I believe that this is an eminently practical way of approaching this extremely important area of trading. Now I want to say a few words about position size. Let us assume that you have just devised a new system and that your testing of this system has led you to believe that it is excellent. Let us also say that you have £100 000 of trading capital and that you can hardly wait for those megabucks of profit you are going to make – so off you go, at least 10 contracts right from the start. Right? No, wrong! Paper trading is useful, testing is useful, but when you start to play for real the game changes, if only because you start to hit emotional/psychological problems you never even dreamt existed. These problems can be overcome but when you enter a new arena (i.e. actually trading your new system/approach) then you must minimize your risk – indeed good traders minimize risk at all times. So you don’t trade 10 contracts, you trade just one. And you keep trading just one until your actual results confirm that you should increase position size. At that point the area of risk (new territory) has become more quantified and you can move ahead without that being such a worry. It would then make sense to increase position size in appropriate steps. What you stand to gain from this approach is obvious. If your system had some flaws then you do not lose all your capital and you also develop some discipline along the way. What do you stand to lose? Just a little time. If all goes according to plan you may well be trading at the size you originally wanted to just a few months later – and in real terms that is nothing. What I find frustrating is that I can explain this to consultancy clients until I am blue in the face but then they often ignore the advice, go off over-trading, survive for a while, maybe even make some money, then that trade with their number comes along and its “adios amigo!”

Monitoring position

Another area where we can reduce risk is in careful monitoring of a position in the early stages. Sometimes when looking at a bar chart it is obvious where the market diverged from the expected path. Such divergence is a warning sign and often a very strong one. Indeed one factor I have noticed is that once a market diverges from a pattern that often a very strong move comes in the other way. The logic of this is fairly clear in that there will be plenty of traders, following the original signal, who will be caught out by just such a move. To an extent the need for careful monitoring will depend on your entry methodology and the logic/philosophy behind it. If you are looking for entries which ought to catch “unacceptable” prices then you would want such prices to be swiftly rejected by the market. The lack of such rejection might be a reason to exit a position. After all you are looking for the best opportunities and one which does not show such rejection may well not make that grade. Such things have to be related to each individual’s trading style and time frame. But this is where a real time price service can pay for itself. Signal, Tenfore, or Market Eye, for example, all cost considerably less than £300 per month and that is only 30 points on a FTSE futures contract. Of course then you need to be around to watch the screen, but the danger area is at the beginning of the trade. That is when you are most vulnerable, so it is really a question of monitoring the progress early on; once the trade has gone the right way traders can relax a little.

Stops can be a central feature of an MM system. There are various ways in which stops can be utilized and these will be covered in Chapter 15.

That concludes our brief resume of some of the more important points of MM, a subject of many books. But it should serve to prompt a few thoughts about how you might be able to improve your approach to the market.

SUMMARY

 Good Money Management is the key to success. Without it even the best trading system would wipe you out.

 A good MM approach means adopting a low risk approach to each trade. If you don’t do that it is a racing certainty that you will be wiped out.

 Starting with a new system you must use just one contract until your results, i.e. profits, prove that it works for real.

 Early and careful monitoring of a new position can minimize risk even more, but don’t be suckered out prematurely.