by: Harvey Walsh
So far we've looked at how not sticking to a strategy, and not planning our trading will inevitably lead us to loss. Now I want to talk about one aspect of planning in more detail - money management.
You're probably thinking that's a really really boring subject, but before you decide to skip this article, let me say that money management isn't just about making sure you survive long enough to turn a profit, it can also open up whole new trading opportunities to you.
Mistake Number Three - Not Understanding Money Management
There are two distinct sides to this subject, and for some unknown reason, most people only ever talk about one of those - survival - or what I call classic money management. It is hugely important though, so let's cover that right now.
The idea is simple; firstly, we have a pot of money to trade with. Secondly, as we have established, losses are a part of trading and so there will be times when the cash in that pot decreases instead of increasing. Therefore, it stands to reason that if we don't manage that cash correctly, it is entirely possible that we lose it all and can no longer trade.
So the concept of classic money management is to trade in such a way that our losses do not disproportionally affect our ability to trade. An example will make this clearer:
Assume we have a starting balance of $5000. We want to ensure that we can survive in this trading game for at least six months - long enough to prove our strategy and ability, and to turn a profit. At its simplest, we could say therefore that the maximum we would allow ourselves to lose each day is $40. If we hit that limit, we would stop trading for the day. This would keep us "in the game" for our six months assuming the worst case scenario of losing every day.
We could expand this money management strategy to say that if we lost our maximum limit of $40 a day four days in a row, we wouldn't trade on the fifth day of the week, and if we lost 3 weeks in a row, we wouldn't trade the last week of the month, and so forth. If we were losing as badly as that, clearly something would be wrong either with the strategy or our ability to execute it and so these enforced breaks would offer a chance to step back and analyse where we were going wrong.
Assuming a $40 a day maximum loss, it stands to reason that we could not enter any trade where the possibility for loss was greater than $40 - to do so would be to expose our account to a greater loss than is permissible. So our daily limit gives us a starting point for calculating risk and reward ratios for actual trading setups.
Knowing beforehand the maximum we can lose in any one day or on any one trade gives us a huge psychological advantage in our trading, as well as keeping us in the game for long enough to allow our strategy to turn a profit.
There is as I mentioned, another side to money management - position sizing. Many traders will trade fixed position sizes based on the availability of funds. This is perfectly valid, but it means that when looking at instruments to trade, they are inherently limited in what they can trade. Dynamically adjusting the size of position a trader is willing to take in relation to the cost of the underlying instrument can open up whole new trading possibilities.
For a much more detailed expalanation, I refer you to an article I have previously written on the subject, you can find it here.
Action: In order to give ourselves the best chance of survival in the market, we must define clear money management rules for our trading, based on our available capital. Doing so will give us the added benefits of relieving the psychological pressure involved in taking losses, and opening up new trading possibilites that may previously have been thought too risky.
With our strategy, trading plan, and money management taken care of, we're ready to trade! In the next article we'll look at another error that too many traders make in their impatience to earn big profits.