by Ann C. Logue, author, Day Trading for Dummies (second edition, Wiley 2011)
Traders love military metaphors: they keep copies of “Art of War” on their bookshelves and talk about attacking the market. And, they need to keep some powder dry.
You can’t trade if you don’t have money. Margin will only get you so far; you have to have some cash in your account before the broker will extend you credit. Money management is the process of determining how much of your account you should place on each trade, and it can make or break you as a trader. The better you manage your account, the more profits you can gain from your winning trades. You will be able to keep powder dry so that you can charge forward another day.
Risk, Return, and Ruin
Obviously, you trade in order to make money. Still, every trader has losing trades, bad streaks, and negative returns. The down periods can be long and miserable, too, but you can survive them. The trick is to have more winners than losers. If one loser wipes out all your capital, though, you won’t be around for the next winner.
Traders take risk in order to get a return. Different traders have different preferences for risk. The market, meanwhile, is relentless. It cares nothing for your risk preferences, it just does what it does. Some days, that’s great. But other days, that’s not. A long series of losing trades can ruin any trader That’s why a key starting point has to be finding your probability of ruin. How likely is your account to be annihilated?
The first number you need to find is your advantage, which is the percentage of winning trades over losing trades you are likely to have. It should be more than 50%, but it may not be a lot more. You can get this from your trading diary or your back-testing data. If you find that 55% of your trades are winners and 45% of your traders are losers, then your advantage is 55% – 45% 10%. Using this number (call it A) and the number of trades you can make in a day (which you can call C), you can find your probability of ruin:
If your advantage is 10% and you can make 20 trades in a day, then your probability of ruin is
In other words, on any given day, you have a 1.8% change of losing all the money that you trade that day. If you trade all of your money, then that day will bust you. You can reduce your risk of ruin by finding a strategy that gives you a greater advantage or by making more trades, if those are feasible for you.
Calculating the risk of ruin is your first step. The higher your number, the more money management matters to your success.
Sizing Up Your Trades
There are several different systems used for money management, and your choice and how you apply it will be as much art as science. Each system starts with a mathematical calculation that you can work out on your own or through the money management tools found in most day trading software packages. And each will put limits on how much money you commit to a trade in order to limit the damage done by your losers.
Money management only works if you stick to it, and some traders are reluctant to do that because they think that it will keep them from making good money on the best trades. Why not throw all the funds you have at a sure thing? Well, because if the sure thing turns out to be a pathetic loser, you’ve lost it all. Moreover, if you have all of your money committed to one trade, then you have no funds to place on the next trade, which might be even better. Money management helps ensure that you have funds to place on good trades by limiting the dollar hit of losses on bad trades.
Three of the easier systems to use are fixed fractional and martingale. They are hardly the only systems out there, but the other systems that traders use are usually variations of these.
Under the fixed fractional system, you first determine how much of your account you want to risk on each trade. This will depend in part on how many trades you can make at once with your strategy, and it should be 10 percent or less in most cases. You need two more numbers: the dollar value of your account and the dollars you could lose on a given trade. Suppose you have an account with $50,000 in equity and you trade stock using stop loss orders to keep your risk of loss on any share of stock to $5. (Trade risk has to be a positive dollar value, so if you think of percentage loss, convert it to dollars for any given trade to do the calculation.) If you have decided to trade only 8 percent of your account, the number of 100-share orders you should trade can be found with this equation:
If you plug in the account data,
you get an answer of 800. In other words, if you limit your losses to $5 per share, you can trade up to 800 shares at a time. Worst case, you may lose $4000, but you will still have $46,000 available for the next trade.
Under fixed fractional, the second trade would be adjusted for the results of the first. If you now have $46,000 in your account, you can trade 736 shares (which would probably have to be rounded down to 700). If you made $4000, though, your account equity would be $54,000, giving you a trade size of 864 shares. That would most likely have to be rounded down to 800, but over time, you’d be able to increase your position size.
The martingale system was developed centuries ago for casino gambling, and it is popular with many traders. You start with a trading dollar limit, so if you have a $50,000 account and want to limit your first trade to 8 percent, then your trade limit is $4000. You open the day with a $4000 trade. If it pays off, then enter your second trade at $4000. If it does not work, then place a second trade for twice the amount – $8000. If the $8000 trade works, your next trade goes back to $4000. If it does not, then double it again – to $16,000. Martingale has one major drawback – you can run out of money if you have a series of losers, which is possible when the financial markets are under stress and rising or falling rapidly. In ordinary trading conditions, though, it can work quite well.
The fixed fractional system is one of several that limit the percentage of money that you can commit to any one trade. Any of these will keep you from running out of money, which is especially important in volatile markets. Of course, this is a mathematical formula; your account equity could become so small that you cannot meet a minimum trade size. Martingale can increase your return over time, if your account size is large enough, your initial trade is relatively small, and the returns are normal.
Thinking Beyond Your Trading Account
If your account size declines enough, then you are out of the trading game. It happens; even people with day jobs face layoffs and firings. That’s why there’s a third component of money management that goes beyond risk calculations and trade size: pulling funds out of your trading account. Come up with a schedule for withdrawing a percentage of your equity and moving it to an investment account: a tax-advantaged retirement account, a long-only mutual fund, even bank CDs. If your day trading is your occupation, determine a regular salary amount and transfer that to your checking account.
If you aren’t trading in order to make money, then take up World of Warcraft instead. It will be a lot safer!
The enemies of the trader are doubt, fear, and greed. Money management can defeat them. If you know your risk of ruin, you can conquer fear. If you have a set system for sizing your trades, you can reduce your doubt. And if you build assets outside of your trading account, you won’t need to be greedy in your trades.
Like war, trading is as much about mentality as it is about tactics. Your armor is money management.