On the first day of the ATIC, I attended mainly the free sessions. One of them that I attended is “Money Management” conducted by Stuart McPhee, a professional trader from Australia and editor of “The Traders Journal”.
Money management is one of the three pillars to trading success, the other two being your psychology and the system you use. If you were to ask professional traders what makes a successful trader, most of them will give a higher weightage to money management than to the system itself. Stuart McPhee has this weightage:
Most novice traders start out by looking for that “perfect system” or “Holy Grail”, thinking that having one will ensure their trading success. Based on the above numbers, that would be a huge mistake.
Other than the fact that such a perfect system doesn’t exist, not having the correct psychology and money management is also guaranteed to ruin you in the long run. Here’s why.
Let’s talk about psychology first. Imagine for a moment that you have a trading system that gives you 99% accuracy. Without the correct psychology, you will find yourself giving manual over-rides to what the system tells you to do. Doing what you were not supposed to do and failing to act when you were supposed to. That is what we term as impulse trading. Trading on emotion is one sure way to financial disaster.
How many times have you traded based on emotion and what were the results of those trades? Trading based on hope rather than on your plan. I’m often guilty of this myself too.
For an emotional trader, it is likely that he will have more wins than losses. However, that one or two losses usually amounts to more than all his winnings.
The other pillar, money management, refers to the size of the bet you take. The maximum amount you can lose on any trade in reference to your trading capital. Here are two extreme examples:
Trader A has a system that gives him 50% accuracy. He has a cut-loss level such that he will lose a maximum amount of 2% of his capital on every trade. To be wiped out of his entire capital, he will need to be wrong 50 times in a row (actually more if his 2% is based on current capital). This is an event that has a 0.0000000000000888% chance of happening.
Trader B has a system that gives him 99% accuracy. He commits 100% of his capital to every trade. Sure, you will see incredible growth in his portfolio initially but that 1% error will come sooner or later. And when that happens, he is left with nothing.
Remember the primary aim of trading is to preserve our capital! That is why money management is so fundamental to our trading success.
Risk is not avoidable and it is important to control it by having capital perservation techniques. This is done by having stop loss levels and more importantly, adhering to them.
A poor entry level can often be saved by a good exit and correct position sizing.
Stop loss levels can be based on one of three things: a technical stop, volatility stop or a retracement stop.
A simple position sizing method is to simply take the maximum amount you can lose on each trade (a good number is 2% of your capital), and divide it by your distance to the initial stop. That is the number of contracts or lots you can make.
Another guideline is not to have more than 20% of your portfolio into any one single trade.
Here are some additional rules by Stuart McPhee for successful trading: