10 Tested Money-Management Techniques - dummies

10 Tested Money-Management Techniques

By Ann C. Logue

The key to success in day trading is discipline. That starts with good money management: determining how much money you will trade, when you will cut your losses, and when you will walk away with money in your pocket. If you don’t manage your money, you won’t be trading long.

Here, you get an overview of the key money-management techniques that you should consider as well as one that is a very bad idea. Some of these techniques are simple; no calculation is required, and you can use them right away. Others involve a little workout with your calculator. A few of these techniques need your performance history to work, so you can’t use them right away, but you can experiment with them as you build your trade data. (And yes, this is one of the many reasons that traders should keep records of trading activity.)

These days, many brokers include money-management calculators and apps in their trading systems, so you can enter the parameters that reflect your trading style and your account balance to get the right amount to trade, right away. These calculators remove the guesswork and mystery associated with some of these techniques — if you use them.

Taking money off the table

Here’s the simplest form of money management: When you’re up, take the profit rather than waiting to make even more money. Fight the greed, take the cash, and call it a day.

If you have a week, month, or year with particularly strong profits, take a little money out of your trading account and put it in a retirement fund, use it to pay off a debt, or move it into a low-risk investment to help diversify your high-risk trading activities.

Even if you do nothing else, taking profits when you have them can help keep you in the game longer.

Using stops

Unless you’re a machine, staying disciplined all the time can be difficult. Humans do goofy things. That’s why there’s a simple way to force discipline on your trading to keep your losses from destroying your trading account: a stop order.

A stop order, also called a stop-loss order, is an order to buy or sell a security as soon as it hits a given price, known as a stop price. The order sits dormant in the broker’s computer until the market price hits the stop, and then the order is executed. This automated action helps you lock in a profit or cut a loss. Some traders don’t like stops because on occasion one will be executed on a one-time down trade or while a stock is shooting up at price, causing them to leave some money on the table. However, stops are an easy way to force discipline into trading. They can help you manage your money with very little extra effort.

Yes, some brokers charge an extra commission for a stop order. But it may be worth it.

Applying Gann’s 10-percent rule

The Gann money-management system is part of a complicated system of technical analysis used to identify good securities trades. The chart system is complex, but the money-management system is simple. The core of it is a limit on the money placed on any one trade to 10 percent of the account value, never more. The dollar value of that 10 percent goes up or down as the account value changes, but the 10 percent limit ensures that you always have some powder dry to stay in the market.

Most traders who follow Gann’s 10 percent rule combine it with stops to limit losses.

You can’t take advantage of a profitable opportunity if you have no money to trade. You can lose everything in your account if you let your losses run.

Limiting your losses with the fixed fractional system

The fixed fractional system is misnamed; it’s actually a range of fractions that determine how much of your trade capital to risk on any one trade. A larger fraction is allocated to less risky trades; a smaller fraction to more risky ones.

To do the calculation, you need to know how much money you can lose on any one trade. The study needed to determine that amount can go a long way toward improving your trading without getting into the math. Fixed fractional takes the stop a step further; it helps you limit your losses and pick up more from your wins by considering how much to trade along with the potential value of losses and gains.

Increasing returns with the fixed-ratio system

The fixed-ratio system of money management is related to fixed fractional trade sizing. The key difference is that it looks at accumulated profit rather than total account size. (Accumulated profit is the value of the account less the capital that you put into it when you started trading.)

This system was specifically designed for options and futures trading by Ryan Jones, a trader himself. The goal is to increase returns from winning trades and protect profits from losing ones.

Following the Kelly criterion formula

The Kelly criterion is based on some statistical work by mathematicians working at Bell Labs in the 1950s. They realized that it had applications to gambling, so they went to Las Vegas and made a lot of money at blackjack. I kid you not. The casinos changed the rules so that it no longer works at Vegas, but it does work in securities markets.

What this formula does is ensure that you will never run out of money, so you will always be able to place yet one more trade. In the real world, of course, you can reach a point where you still have money but don’t have enough to place a trade.

Kelly criterion

The equation looks at the percentage of trades that are expected to make money (W), the return from a winning trade, and the ratio of the average gain from a winning trade relative to the average loss of a losing trade (R). You may not be able to use the Kelly criterion until you have been trading long enough to amass data to use in the equation, but that’s okay — you have other choices here!

The Kelly criterion often generates a trade size larger than many traders are willing to use. One alternative is a half Kelly trade, using half of the amount recommended by the equation.

Figuring the amount to trade with Optimal F

Optimal F is another money-management system that needs performance figures to generate an ideal trade size. It was developed by Ralph Vince, a trader, and it comes up with the ideal fraction of your account to trade based on your past performance. The calculation changes with every trade, so it’s usually done through a spreadsheet or an app.

Measuring risk and sizing trades with Monte Carlo simulation

The Monte Carlo simulation is another money-management system drawn from gambling. It’s used for risk management in many different businesses, including trading. You enter risk and return parameters into a computer program, and it tells you the likelihood of total loss and the optimal trade size.

The system can’t account for every possible thing that can go wrong, and it requires a lot of computer power — even nowadays. That being said, many trading and brokerage platforms have Monte Carlo applications that can be used to help you measure risk and size trades.

Taking a risk with the Martingale system

Martingale is another simple money-management system, no calculator required. It’s popular with gamblers and traders alike. You start with a small amount per trade — you get to pick it yourself, but it should probably be less than 5 percent of your account value. If the trade works, your next trade should be the same amount. If the trade does not work, then you close it out and place double the amount (double down, as they say) on the next trade so that you win back the loss. That doesn’t work? Double again. After you have a winning trade, go back to the initial amount for your next trade.

If you have to double down for a long series of trades, the money involved quickly grows: from $2,000, for example, to $4,000, $8,000, $16,000, $32,000, $64,000, and even $128,000 if you have six losing trades in a row. This is the problem. If you have an infinite amount of money, you will come out ahead using martingale.

With martingale, you can run out of money before you have a trade that works. The method works best for aggressive traders with large accounts who start with small initial trades. It’s a risky money-management strategy, but it’s also far preferable to having no strategy at all.

Throwing it to the fates

Many traders have a logical problem with money management. If you have a sure thing, why shouldn’t you put all your money on it? If you know the next trade is going to be great, why should you close out the day with a balance decline? Ah, but your logic is colored green with greed.

Few sure things are as sure as they seem. Lose on the sure thing, and you won’t be around for the next trade. Exceed your daily loss limit, and you’ll have even greater losses.

The wise sage Bart Simpson once said that years of watching television taught him that miracles always happen to poor children on Christmas Eve. Knowledge of money management is more of a sure thing than believing that you will be the beneficiary of a miracle today.