This has been taken from http://blog.bigmiketrading.com/ - its not my site and no its not an article selling a 'winning system to beat the pros!' - its simply good advice for any new trader.
Money Management Rules
Sunday, March 7, 2010
Here are some Money Management thoughts. I came up with these after having a quick conversation with another trader who, in my eye, has very weak money management skills.
He's been trading stocks and doing ok, but he often averages down and his approach has been to just buy more if it goes against him. He has a very large account and in terms of position sizing he tends to leave himself some room to average down, but this obviously is an extremely dangerous game. One single bad trade could wipe out months of gains if you keep averaging down until your leverage is exhausted.
At any rate, the trader is now venturing into futures and I wanted to instill upon him the importance of sound money management. Profitability is all about money management and discipline.
So I covered some of the basics, which I will lay out here as well:
- Assuming a 25,000 account size.
- Use 1% risk, meaning no one trade can lose more than $250.
- Require a 1% reward, or better. This means your edge has to have a win/loss dollar ratio of 1:1 or better.
- Trader is going to trade CL. With 1% risk that means he cannot trade more than 2 contracts (even that is pushing it) with $25,000.
- As the equity builds, we can add a third contract and that third contract is really where the majority of profits will probably come from. It will be the true runner and raise the win/loss dollar ratio beyond 1:1.
- The edge must have a positive expectancy, and it will with a win percentage of 65% or better.
- Set daily, weekly, and monthly stop-loss and profit-target goals to tell us when to stop trading.
Now that's a lot of stuff, so lets break it down into some real-world examples before going further.
After researching the edge, it is the belief of the trader that he will trade approximately 5 times a day. That's 25 times a week, and roughly 100 times a month. It is believed that the edge (again, after research) is right about 65% of the time, and we are using 1% risk and 1% reward (equal).
Specifically, we're using a 12 tick stop and a 12 tick target, and will trade 2 lots on CL until the equity is sufficient to where we can add a third lot, and so forth. We need an additional $12,000 of equity for each lot we trade, using a 12 tick stop and 1% risk.
- Five trades a day
- 12 tick stop per contract
- 12 tick profit target per contract
- 2 lots
With CL, 12 ticks is really a very inefficient way to exit a trade. But until we add a third target, it can be difficult to do so otherwise. With a third target, a runner can be left on and very easily capture enough ticks to equal 2 or 3 whole trades (24-48 ticks on the runner). In fact, with CL quite often runners can go for 80-100 ticks.
You might question why we're waiting for a third lot before doing a runner. Why not do a runner with lot #2? It is possible to do it, but after having talked about it I felt that due to some psychological reasons (and not pure math) it would be far better to implement a "it's either a winner or it's a loser" trade mentality in the beginning. That means that we want to make it simple. Does the edge really exist? If so, then we'll know, and until we know 100%, we are going to keep it as simple as possible. That means there is no order management mid-trade. No breakeven stops, etc. All in, all out.
Ok so if we anticipate trading 100 times a month, with a 65% win rate, and our WLD ratio is 1:1, and we trade 2 lots with a 12 tick target/stop, that means each winner or loser is $240, plus commission which is $10. So a net winner is $230, and a net loser is $250. So already you can see that when you factor in commission, our WLD ratio just dropped from 1:1 to 0.92:1.
If we win 65% of the trades, that means 65 out of 100 trades are winners ($230 x 65) for $14,950, and 35 out of 100 trades are losers ($250 x 35) for $ 8,750. That leaves us with a net profit of $ 6,200, which on a $25,000 account would represent a 25% gain in one month's time.
At that rate, we would require two months of back-to-back winners at the 65% win rate before we accrued enough winnings (and assuming we do not take a draw out of our account) to be able to add the third lot (runner).
Now remember, the 65% win rate, the 12 tick stop and target, and the 5 trades per day were all factors provided by the customer who after doing his own research believes those figures to be true.
Time will tell
But, just in case everything is not perfect -- I advised the trader to make some firm contingency plans. That is where the daily, weekly and monthly stop loss limits and profit target limits come in.
Let's talk about the loss limits first:
- Daily loss limit: 5 losing trades
- Weekly loss limit: 15 losing trades
- Monthly loss limit: 50 losing trades
If the trader expects to trade five times a day with a 65% win rate, that's approximately 2 losers and 3 winning trades per day. So it seems logical that in any one single day if you experience 5 losers, something is not working quite right and it's a good idea to stop trading for the day (both from a psychological standpoint as well as from a market behavior standpoint, ie the edge is not working today).
If the trader expects to trade 25 times a week with a 65% win rate, that's approximately 9 losers and 16 winners a week. So again, it seems logical that if you've hit 15 losing trades you should stop for that week.
And again, if the trader expects to trade 100 times a month with a 65% win rate, that's approximately 35 losers and 65 winners a month. If you hit 50 losing trades in a month, it seems logical that something is not working right and you should stop. You may only be 2 1/2 weeks in and you don't trade the remaining 2 weeks, but that's the way it is.
Now let's talk about profit targets:
- Daily profit target: 7 winning trades
- Weekly profit target: 30 winning trades
- Monthly profit target: 100 winning trades
We add the daily targets so if the edge is performing well we are allowed to keep trading past the "typical" or "average" but not so far as to start impacting us psychologically and risk over trading.
Having both sets of limits also allows us a little leeway, so for instance if we had two bad days we could trade more than 5 times a day for the remaining three days a week if those days are better, so that we can make up for the losses we took early on.
The idea is that you keep trading until you hit one limit or the other. If the daily stop loss limit is 5 trades, the the winning limit is 7 trades, that means if you have 4 losers and 6 winners you take one more trade. Same for weekly and monthly. But once you hit either side of the limit, you must stop.
The limits are designed to minimize psychological impact as well as minimize dramatic shifts in your account size. Consistency is king here. Our task at hand is to prove whether or not we really have an edge, and whether or not it is the size we thought it was, the frequency we thought it was, etc. Our goal is not to double our account in one month, our goal is to prove the edge. Even if an edge works out to be only 2% per month, that's 24% a year and when you start compounding, that is astoundingly HUGE. You could soon rule the world with a return like that, so remember to keep your goals modest or they will humble you.
This is a good exercise -- in fact it's a "must" -- for any trader who's purpose is to be profitable and believes they have a defined edge.