Trading Money Management System

Trading as a business requires good money management and record keeping. Trading money management can make a mediocre trading strategy profitable. Poor and inconsistent money management can make a great strategy a loser. The number one sin is trading to big. Trading too big for the account size has ruined many traders. Even the great Jesse Livermore over leveraged his account and went bust at the end of a long brilliant career.

Although trading too big is the number one cause for the ruin of many otherwise talented traders, inconsistent risk management is its evil twin. Both are forms of gambling and can be the cause of many self defeating character traits: fear, greed, impatience, revenge, despair, and depression.

Some trading systems or market conditions may produce a low batting average, but offer a reward to risk ratio that is high. At times, you may have to endure long strings of losses before showing a profit. If your unit of risk is too large, your tracing account will run the risk of ruin. Open up a demo account and risk 10 to 20% per trade. See how long it takes for you to go bust. Yes, you may get lucky, but do you really want to gamble?

Risk and Risk Units

Your unit of risk depends on your risk tolerance as well as your Batting Average and your $Win/$Loss Ratio. Experience and good record keeping will guide you in determining your ideal risk amount. As a general guideline, choosing risk percentages in the range between 1/2% to 2% should keep you from blowing up your trading account, assuming you have a proven edge. You should risk even less until your records show that you do have an edge.

Let’s go through an example that will demonstrate good consistent risk management. I’m going to choose a risk unit of 1% for a trading account of $200,000. That means, I can risk $2000 on a single trade. When I raise my stop loss to break even, I am no longer risking 1% or $2000.

If my entry is $62.35 and my Stop Loss is at $58.75, how many shares can I trade, based upon the rules I have create above? $62.35 minus $58.75 equals $3.60. A Risk Unit of $2000 divided by a Stop Loss of $3.60 equals 555 shares. If I miss my entry by a nickel or a dime beyond my planned entry, then I MUST recalculate my Share Size.

Batting Average

When you use a consistent %Risk Unit, you will be able to calculate a Batting Average that has meaning. A batting average of 90% is meaningless if your risk is inconsistent. You could have 9 small winners and one big loser, wiping out all previous gains.

$Win/$Loss Ratio

Once you have a consistent risk unit you will also be able to calculate a meaningful $Win/$Loss Ratio. Let’s take a database of 6 trades, 3 winners and 3 losers, a 50% Batting Average. The losers were all consistent at $2000 each for a total of $6000. Our winners were $2500, $1500, and $5000. The total amount for our three winners is $9000. Our $Win/Loss Ratio is $9000/$6000, or 1.5.

A 50% Batting Average combined with a $Win/Loss Ratio of 1.5 is very respectable. You can make a healthy living for the rest of your life with these statistics. If you don’t know what these statistics are, then you are gambling. It all starts with choosing a Risk Unit that is the ideal size for your trading account, experience, and track record.

Capital Exposure

One last thing. Keep some of your powder dry, especially when you have multiple trades on at the same time. If for example, you are a swing or position trader, using 2 X 1 margin, limit your capital exposure to some amount that is less than 200%, such as 180%. You never know when a position may go against you suddenly, gapping past your stop.

Total Risk Exposure

It is also an excellent idea to limit our total risk exposure. %5 is a good number. That means that we can put on 5 trades, each with a Risk Unit of 1%. As we trail our stops to break even and above, our Drawdown Risk diminishes. As we take profits or partial profits, our Capital Exposure also diminishes. We are now able to take on new risk with new trading ideas.

Seasoned traders who have survived the school of hard knock become risk averse. They define their risk and study their statistics. Then they find ways to improve what is working and eliminate what isn’t working.