Money management is often confused with trade management, such as where to place a stop, where to enter, and where you exit.
Money management occurs when, before you enter the market, you ask yourself: What is the biggest drawdown? How fast do I want to increase the risk to optimize profits without ruining my account? In which scenarios will the account be ruined due to excessive drawdown?
These are the questions that every trader ultimately needs to answer, whether they do it consciously or not. Either they default to some kind of formula or they just pull something of their hat and say “Well that looks like a good trade, so I’m going to trade five contracts today.” Position size is a crucial part of your overall success with any trading strategy.
Most successful investors such as Warren Buffett and Howard Marks emphasize risk is their number one focus. Whereas, most traders and investors emphasize profits as their number one focus. Where your focus is what determines your long-term success in making money from the markets.
Unfortunately, the herd mentality still dominates most people’s psychology. When the media start to heavily cover a bull market, such as the internet bubble in 2000, the housing bubble in 2008, and the bitcoin bubble in 2018 it is already too late to jump in. During a market crash, many people are busy liquidating their assets at rock bottom prices, when they should be buying.
What is money management and its objective?
In an essence, Money Management is the combination of the three pillars which underlie all trading success: a good trading system or strategy, proper money management, and right thinking. There are two objectives to money management: 1) to optimize the earnings, and 2) to avoid the risk of ruin. Risk of ruin takes on two forms: 1) capital loss and 2) psychology stress.
There is a tradeoff between wanting to earn as much profit as possible versus decreasing the drawdowns to manageable levels. To come up with the best combination of reward to risk, the overall efficiency of the system needs analysis. If too much capital is lost, trading is stopped either for financial reason or because of the emotional, and/or mental stress. Therefore, proper money management requires addressing both issues – financial ruin and psychological stress, which could cause a person to liquidate their assets prematurely. A person may have the finances to withstand big drawdowns, although it does not always mean one has the emotional and mental fortitude to tolerate big drawdowns. Emotional stress is often hidden inside us and unbeknown to us it affects our trading decisions.
Walking across a piece of plank six inches wide raised from the ground one foot will cause little stress for most people. However, stretch the same six-inch plank between two high-rises, and the stress level gets too high for almost anyone. As the perceived or unperceived subconscious risk increases, the subtle impulses sent by emotions cause each to deviate from the trading plan. This is why we stress the importance of psychology of stress, because trading psychology is so very important to your overall success as a trader.
Since the causes of stress are often hidden, it is difficult to know what is causing the counterproductive behavior to trade success. Some of the hidden factors can be the impressions received from parents and society, emotional traumas, and beliefs that are counterproductive to trading. Each one of these is a vast subject that can take a long time to resolve.
Actions or lack of actions one takes is the self-evidence that something is amiss. If you find yourself not succeeding, because you are unable to follow a trading system, or you find yourself executing a lot of bad trades and missing the good ones, and not following common sense money management rules consider taking a step back to find the potential causes within you.
Everyone has different talents. If you find that you are lacking in the talent of executing trades, a solution is to hire someone to do the trades for you.
What are some issues addressed by money management?
- How much capital do you place on each trade?
- Capital preservation verses capital appreciation.
- If you are on a losing streak do you trade the same amount of contracts/shares?
(for the purpose of this article contracts and shares are synonymous)
- How your trading is adjusted with accumulated new profits.
- How is volatility handled?
- How do you prepare yourself psychologically?
The preservation of the principal capital should be of utmost importance. If the risk taken is too big and at the onset of trading a bigger than expected drawdown is encountered, the principle equity can meet with ruin – either financial or emotional.
To begin with as little as possible should be risked from the principal equity. As the profits increase the risk can be brought to a normal. This is the best strategy to preserve capital, and to reduce stress if an unexpected big drawdown on equity is encountered.
To protect the principle capital against the biggest drawdown, the first few trades should be as conservative as possible. By starting slower, the goal of reaching two-fold profit is only delayed by one or two months. That is worth the preservation of capital. As soon as there is some profit, the risk can be increased. If the initial profits are given back then the risk should be reduced back down to the original number of contracts.
Since with passing of time, the chance of encountering a larger than expected drawdown increases, after the initial growth of equity, more conservative money management should be used. Keep in mind that since the equity is larger, the gains generated from less aggressive money management will still be substantial.
Periodic what if tests should be done on the performance record to see what the potential drawdowns will be and your risk can then be adjusted accordingly. If the volatility of a market goes up it will be necessary to adjust the number of contracts purchased.