Traders Toolbox: Money Management Part 2 of 4

Crucial but often overlooked, money management practices can mean the difference between winning and losing in the markets.

-Amount Of Money To Risk- It's difficult to come up with hard and fast money to risk on different markets and trades. For our purpose, though, it's best to think conservatively. Although some studies suggest initially allocating equity in broad terms of original margin (40% to 50% of total equity committed to the markets at a given time in the form of original margin, 15% to a particular market, 5% to a single trade, etc.), many traders consider these percentages too high, and do not consider the market to be a accurate measure of risk or a sound basis on which to allocate funds, because a trader can always, technically, lose more than the margin amount. These traders find it more beneficial to think in terms of the actual money amount they are willing to lose on any particular trade or trades, determined by their stop level or through some other calculation.

Although in specific circumstances professional traders may actually risk comparable or even greater percentages of total equity than those listed previously, on average they risk much less-perhaps 12% to 20% of total capital at a time, and 2% - 4% per trade. Depending on the size of your trading account, these levels might seem overly strict, but again, the idea is to conserve money for the long haul.

In developing your trading goal, determine how much you could accept losing on a trade, both financially and psychologically. Based on total capital and the number of markets in which you are active, allocate your equity proportionally between individual trade, market group and total trading activity levels.

These guidelines protect you from dangers of extreme leverage in the futures markets. Though it may seen attractive to have the change to make big money on a small initial investment, the risk of loss is just as great.

-Determining Reward/Risk Ratios- Another common rule in trading is never to put on a position unless your possible profits outweigh your possible losses by a ratio of 3 to 1, or at the very least 2 to 1. So, if a particular trade has the potential of losing $100, the profit potential should be at least $200 to $300. This is not a bad rule, but like so many aspects of trading, it is somewhat intangible. Once you have formed an opinion of a market, determined your entry point and calculated the maximum amounts you could win or lose on a trade, you still are left with the uncertainty of the probability of your trade winning or losing, and unfortunately there is not secret formula for removing this uncertainty.

Some traders don't consider probabilities valid at all. The most any trader can do is perform his or her best analysis of the market, and, along with experience and intuition, come up with some rough idea of the probability of success for a given trade. This probability can then be weighed against the reward / risk ratio in selecting trades. For example, would it be better to put on a trade where the reward / risk ratio is four to one and the probability of success is 30%, or would it be advisable to put on a trade where the reward / risk ratio is only two to one but the probability of success is 75%? Using this rule, you'll be ahead of the game by directing resources to the trades with the greatest chance of success.

Traders Toolbox: Money Management - Part 1 of 4

Crucial but often overlooked, money management practices can mean the difference between winning and losing in the markets.
Plenty of books, manuals, and software packages will help you form and opinion of a market, but not many will tell you how to trade once you have decided to get long or short. The goal of money management is to increase the odds of high quality trades. And as we'll see, leaving the money management variable out of your trading equation can lead to ruin, even if you're correct about the market direction.

In a broad sense, money management can encompass those elements of trading outside the initial decision to get long or short in a given market or markets – that is, how many positions to put on, when to get out, where to place protective stops. More specifically, it refers to the strategic allocation of capital to limit risk and optimize trading performance in the long run. Allocation of capital can refer to how much money to put into any one market or how much money to risk on any one trade. These decision directly affect how many positions to put on and where to place stop orders.
Given the negative odds inherent in trading (a successful trader can expect to lose money on 60% of his trades), how do you go about maximizing the profit potential of the few winning trades you can expect to have? The answers vary with the disposition and trading style of the individual trader. There exist, however, basic concepts that can be successfully adapted and modified to individual needs, and when the followed in spirit, can boost the promise of long-term trading profits and take some of the stress and uncertainty out of trading.
-Establish A Goal- Having a clear idea of what you want to accomplish by trading, whether it is a short-term profit on a single trade or the desire for a long-term trading career, can go a long way toward building successful trading habits. Regardless of whether or not the goals are set on a per trade, daily or long-term basis, establishing from the outset basic levels of acceptable risk and financial reward will help curtail avoidable risk and extreme losses. Also, determine a specific time frame in which to trade: Will a position have to be liquidated by a certain time for tax purposes or for same other reason?

-Diversification- Just as in the stock market, a portfolio of different instruments can be one of the best hedges against several and unsustainable losses; a loss in one market will hopefully be offset by gains in others. Traders must take caution, though, to truly diversify their portfolios with contracts that are price independent. Spreading your trading among three or four different interest rate contracts that move in a similar fashion is not a good example of diversification, because a loss in one contract is likely to be mirrored by losses in the others. But over-diversification is dangerous, too. A trader can spread his money over too many markets, and not have enough capital in any one of them to weather even small adverse price swings.
A good rule of thumb is to stick with what you are comfortable; do not venture blindly into unknown markets just for the sake of diversification. A balance must be stuck between available resources and a manageable trading scenario. Capital constraints will, of course limit the choices traders can make, forcing those with smaller trading accounts to bypass or minimize diversification.