Money Management FAQ

As you can see I am taking the time effective route for my blog posts today. I have a deadline I need to meet by tomorrow and I am desperately behind. I had outlined some thoughts on money management, but haven't had an opportunity to let my pen bleed yet. Therefore, I am going to recycle a good Money Management FAQ I received several months back. This is a great start to get some of the basics covered before I add my two cents.

Rest assured, I won't be this negligent forever. Tomorrow is another day!

In the twenty-first century it has become fashionable to manage one's own investments, yet few traders implement disciplined, professional money management strategies. During the stock market bubble, limiting risk was an afterthought, but given the recent price action, it’s time to get serious about management of money and risk. Professional risk and money management strategies are the foundation for success. Essentially, money management tells you how many shares or contracts to trade at a given point.

Money management is a defensive concept. It keeps you in the game to play another day. For example, money management tells you whether you have enough new money to trade additional positions. Don’t confuse money management with stop placement. Stop placement does not address the how much question.

Money management is risk management. Risk management is the difference between success or failure in trading. Trading correctly is 90% money and portfolio management, a fact that most people want to avoid or don't understand. Once you have the money management down though, your discipline and psychology is 100% of your success.

Money management optimizes capital usage. Few have the ability to view their portfolios as a whole. Even fewer traders and investors make the move from a defensive or reactive view of risk, in which they measure risk to avoid losses, to an offensive or proactive posture in which risks are actively managed for a more efficient use of capital. Trend Following risk management formulas and philosophies are key to increasing profits while controlling risk.

Q. What are some issues addressed by money management or bet sizing?

A. For example:

How much capital do you place on each trade?
What is the heat of your trading.?
Capital preservation v. capital appreciation.
When do you experience expectation of success?
When must you take a loss to avoid larger losses.?
If you are on a losing streak do you trade the same?
How must you prepare if trading both long and short positions?
Does a portfolio of long and short allow one to trade more positions?
How is your trading adjusted with accumulated new profits?
How is volatility handled?
How do you prepare yourself psychologically?
Have you tested your bet sizing?

Q. Does money management impact a decision to trade the same number of contracts or shares in all markets?

A. Yes. Money and portfolio management rules dictate the number of contracts or shares. Precise formulas set forth size. A trader who uses a constant trading size gives up an important edge in much the same way a blackjack player does when always betting the same regardless of what cards are on the table. Common single contract/share measures of trading system performance such as win/loss ratio, percent winning trades, etc. are of little value to decision-making when using Trend Following systems (and the Turtle system). Often the best trading approach, when tested on a single contract/share basis, will turn out not to be the best approach when money management strategies are incorporated.

Q. What about short term trading? Isn't short term less risky, and therefore you don’t need money management strategies?

A. Short term trading is not, by definition, less risky. Some people may mistakenly apply a cause and effect relationship between using a long term strategy and the potential of incurring large loss. They forget profit and loss are proportional. A short term system will never allow you to be in the trend long enough to achieve large profits. You end up with small losses but also small profits. Added together, numerous small losses equal a big loss. When you trade for the long term, you have a more positive expectation in terms of the size of the move. In the big picture, the larger the move, the larger the validation of the move. If you were trading some short term pattern predictive system you would never be able to participate fully in the big trends. Big trends make the big profits.

Q. How does money management impact drawdowns?

A. All systems have drawdowns. You can't have a profitable methodology, without taking some calculated risks as well as some losses. Trend Following drawdowns are a function of the risk level desired. Risk level among Trend Followers varies depending upon the size of the profit they seek. For example, if you sought 100%+ a year gains you must be prepared for the possibility of a 30% drawdown. Anyone who promises you can make 100%+ with only the possibility of a 5% drawdown is lying.

Q. Can you manage margin issues?

A. Required margin has little to do with money management considerations. For example, if the margin was dropped from $5000 to $2500 on a particular stock or commodity, must you trade twice as many shares or contracts? Of course not. Margin issues are not money management.

Q. Is slippage a concern with money management?

A. No one wants bad fills. But Trend Following for the long term places far less emphasis on perfect fills for success. In contrast, short term traders' transaction costs and skids on their fills affect their bottom line to a much greater degree.

Q. What is the win/loss ratio of Trend Following management? Can it experience many losses in a row?

A. Trend Following systems (and the Turtle system) trade for the outsized large move. Several big trends a year are your key to success. The strategy cuts your losing positions quickly. Consequently, a few big trades will make up the bulk of your profits and many small trades will make up your losses. Winning trades can range from 35-50%, but that percentage reveals little information since we expect more losses (of smaller value) than winners (of much larger value). Win/loss ratio, while a favorite of the novice trader, has limited use in terms of Trend Following analysis.

Jeff, any re-inforcement in this area is greatly appreciated. I just got finished slicing and dicing every trade from last year. The flaw in my trading is really this area. This year I add writing in my trade journal..."I will honor my money mangement trechnique".
Just like in Caatholic school when the nun would make you write 1000 times on the board, "I will not talk in class". I am going to write every day my money management rules in my daily journal until it is embedded in my mind.
thanks
Jamie

just sharing a quick trade:

FFIV 65/60 bull put spread is paying .95. the short strike is 10 points OTM and below two strong areas of support.

lisa

Jeff,
Thanks for the great article. Money management is foremost on my mind as I've had a horrible week and for the first time find myself thinking "I can't afford to take more losses here... what am I thinking." For example... bought puts on HYSL yesterday on a confirmed triple top and no major movement on yesterday's earnings. Then today Radio Shack announces they're going to use Hyperion software in some kind of blockbuster sale and POOF! HYSL is up 15% today. My $0.90 puts are now worth $0.10 The good news is that other stuff is up dramatically so we're covered. But holy crap, Batman... how do I manage to pick these "winners?" But good money management has saved the day and reading the article has helped.
If anyone's into a stock trade... NXY on the Toronto Stock Exchange is a stock I put in my retirement fund a few weeks ago. It's a gas and oilwell stock and has been climbing nicely despite oil's trajectory to the basement. Just heard it's a buyout possiblity at $90 a share and it's trading around $74 today. It's a great stock on it's own... the buyout would be a bonus.
Chris and Catherine

Jeff,
don't know if you have time to read this, what with preparing for Master Talk tonigh (which session?) but I'd be interested in knowing what you think about BXP. We've made quite a bit off it and it looks like it's leveling off right now. In a case like this, I'm assuming you would normally hold on to it until it breaks out of it's trend, which could mean a retracement of almost $5.00 That's what we're planning on doing, but I was just wondering if you have any different ideas on something like this that has a bit of a history of going sideways for over a month, even when it's in such a well-entrenched trend.
Thanks... looking forward to tonight's class
Chris and Catherine

Thank you Jeff for your article on Money Management.

I still have problems letting my losers get to the limit risk and getting out from my winners when I see 10% to 25% ROR. So it is too hard to make increase my account that way. Maybe should increade the risk/reward ratio to 3 or 4. I was taking trades that could give me 2 and exiting with lower ROR % but when they go against me I let them to the risk limit.

The problem is that I had many times trades that were winners and became losers, so in order to avoid that I exit when have some weakness signal.

I would appreciate your advice.

ALessandra Sahonero

Chris&Catherine,

Session 1 tonight. As far as BXP is concerned, let that winner run!!! Nice trade!

JK

Love this article and your blog. Nice job making clear how important money management is to the trading plan.

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  • From Saratoga Springs, Utah, United States
  • I am a professional trader and an instructor for Investools. I've had relations with the markets for 9 years. Born in Concord, CA, but reside in Saratoga Springs, Utah. Father of THREE, Husband of one.
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