Continuing on from my previous post on trading by Ray Barros, this post covers on the topic of money management.
Ray Barros mentioned that 80-90% of newbies will show a loss in their first 12 months of trading. 3-6% even lose their entire trading capital. The single most important reason why this happens is unrealistic expectations.
Professional traders try to make money slowly. Amateurs try to make it quick. For example, making a 10-20% return in a year can be considered a pretty decent return. Some newbies expect to make that same kind of returns in a month. This leads them to take larger positions then they should be taking — often with disasterous results.
A proper money management system defines the risk (amount of capital) you risk per trade by helping you to determine the correct position sizing to take. The factors that affects it include your capital base, the volatility of the market and the expectency of returns.
The expectency can be calculated by taking:
Average $ win x win rate – average $ loss x loss rate
You cannot control your win rate, but you can control your entry and exit prices. These set prices help you to determine the risk you put into every trade, and the maximum reward you can get.
A good risk to reward ratio is crucial for getting consistent results from trading.
Depending on the time frame you are trading, the risk to reward ratio will be different.
The shorter the time frame, the lower the profit you can make on each trade, and the higher your win rate has to be. For example:
Type of trader : risk reward ratio : win rate required
Ray Barros shared with us two methods for determining the correct position sizing. The second method is more complicated and requires data from your trading records, so I will just talk about the first one here.
Decide on the risk you will take on each trade. Typically, this is about 2-5% of your trading capital. Using an example of $10,000 as trading capital and risk of 2%, this works out to be $200.
Suppose then that I enter a trade at a price of $100. Based on technical indicators, I determine the take profit price to be $120 and the cut loss level to be $90.
This trade has a good risk reward ratio of 2.
As the cut loss level leads to a loss of $10, the maximum number of contracts that can be taken is $200/10 = 20 contracts