Now that you have a good idea of what proper money management is, before we get into some different methods for applying it, we are going to review some guidelines that will help you to increase your performance.
1. Control your Trade Risk
Only risk a small percentage of your total equity on each trade. At this point this might be stating the obvious but it is worth mentioning. Even with proper money management, accounts will go up and down. By controlling your risk and letting your edge work, it should be moving up overall.
Use Real Stop Orders – “Mental Stops” DON’T WORK
Anything and everything will happen, all of which you have no control over. The electricity could fail, a new virus outbreak could happen, the Swiss Central Bank could decide to remove their peg again, or a new George Soros could wake up one day and decide to go to battle with a bank.
If you are thinking that brokers are trading against you, then you need to make sure that you are placing your stops where they are NOT likely to get taken out by market noise. There are now tools for hiding your stops from your broker. Isn’t technology great?
2. Limit your Total Portfolio Risk
Often you will be sitting on the sidelines waiting for an opportunity to appear. Then all of a sudden, there is one setting up in every market! Be aware of which markets you are entering trades in and limit the total amount of open risk you have on to 4 full trades.
Depending on the money management method, this could be anywhere from 4% to 20% risk if all the trades closed for a loss. If you are a more active trader and want to enter more markets, you can do so by reducing the risk on each trade.
3. Keep your Reward/Risk Ratio Positive
Depending on the strategy, you want to aim for a 2:1 Reward/Risk Ratio or better. What this means is that your winning trades will make $2 while your losing trades will lose $1. You will make money even if you are only right 35% of the time.
Understand the rules of your strategy and that there is a trade off between the Reward/Risk Ratio and your Win Rate. Going for a larger profit target might result in the market not reaching it.
4. Use Appropriate Stop Loss Placement
Be realistic about where you place your stops. A tight initial stop doesn’t necessarily mean less risk. If stops are too tight for a given market, you might find you are getting stopped out only to see the market run off to your target and beyond. MAE and MFE are great tools to use for testing your strategy for stop placement. The correct stop placement is the one that works best for your strategy and has been proven through back testing.
If your strategy calls for a trailing stop, test out different options, using the price action is a good place to start. Don’t beat yourself up for early stop outs. Leaving money on the table is a sign of a successful trader.
If you catch a substantial move in a short amount of time, taking partial profits is definitely an option especially for short term or day traders, where large gains are fewer. Continue to study the charts and they will tell you the best course of action for that market!
5. Understand Market Volatility
Understand the volatility of the market you are trading and adjust your position accordingly. Some money management methods have this built in while others might need to be adjusted or normalized. This is when you have an opportunity that calls for an extra wide stop loss like in some of the British Pound markets.
Let’s say the risk on your trades in pips is averaging around 80 pips. Then you catch a great opportunity setting up in the GBPNZD market but the risk is 200 pips. Normalizing is when you adjust your position size to compensate for the added risk on the trade. If the trade stops you out for a loss you aren’t putting a huge dent in your account.
Just to be clear, theoretically there is no need to normalize money management. It doesn’t care what you are trading or how wide or narrow the risk is. It is a psychological problem and you can choose to normalize or not.
6. Be Aware of Market Correlation
If you are long heating oil, crude oil and gasoline, in reality you don’t have 3 positions. Because these markets are so highly correlated, meaning the price moves are very similar, you really have 1 position in energy with 3 times the risk of a single position. The same goes for the Forex markets. Be aware if you enter trades in the same direction in the USD markets, JPY markets etc. Markets can also become correlated for a certain period of time. There are some great tools online showing market correlations in real time.
7. Be Adequately Funded
Make sure your money management strategy is appropriate for your account size. If there is a “Holy Grail” in trading, then this is it! Over leveraging your account is the quickest way to go broke. Be prepared for a whopper of a drawdown, one you haven’t experienced before, that could be 2 or 3 times what your historical results have shown. You can find more information about drawdowns in the topic below.
By having enough money in your account you are ready for anything. You can resist even the perfect storm, and continue to trade with confidence.
8. Avoid Pyramiding
Pyramiding is a way of adding to your position. Say you enter a long position with 2 contracts. When it comes time to add to your position you add 4 contracts, and then 8 and so on. Pillaring is a much better way to add to your position. This is adding the same number of contracts as called for by your money management strategy.
Reverse pyramiding is also an option. The best time to add is the first chance you get. As the trend gets longer and longer, chances are increasing that a consolidation period is coming so adding fewer and fewer contracts on your 2nd and 3rd add will keep most of your profits in your account.
9. Adjust During Drawdowns
When you are in an extended drawdown, adjusting your plan to trade “tighter” does work when done correctly and will help you turn it around quicker. Some things you can do are the following:
1. Move your initial stops to breakeven a little sooner.
2. Take full profit at your first target.
3. Take partial profit if the price reverses near your first target.
4. Only take 1 trade at a time and limit your entries to the highest probability opportunities such as only trend following or countertrend setups, whichever has been working better.
Warning: These steps should only be taken when in an extended drawdown which means a drawdown that is larger than expected. All other times you are better off letting your strategy work over time.
10. Having No Position is a Position
Be willing to sit on the sidelines and stop trading. You don’t always have to be in the market. All strategies go through periods of crushing it, but they also go through periods of treading water and times where nothing you do seems to work.
Continue to study your results, what you are doing right and what is going wrong. Also, identify any weaknesses or mistakes you are making. Do another backtest of your strategy to confirm that it still has an edge.
While you will not be making money being out of the market, not losing money is also making money.
11. The Psychological Impact of Losing Money
Unlike the other guidelines this one can’t be quantified. Of course no one likes to lose money, but it will affect each trader differently. Always be aware of the psychological impact it is having on you.
By strictly following your plan and reviewing with your teammates, you can keep your emotions in check and the voices out of your head. Only trade with money that if lost won’t have a big effect on your mental well being, your family or your lifestyle, and gaining valuable experience will help you train yourself to truly accept the risks.
Money Management is more common sense than rocket science. By understanding the methodologies you use and the risks of trading, you will survive and grow into a seasoned independent trader. If you don’t quit, you win!