Money Management

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Money Management

I know many traders (and former traders) that have blown up their accounts (in some cases several accounts) and had to stop trading.   Some have had to give up trading altogether.  This is a very serious issue.   Most people when they start trading are so excited to start, they are quick to open and fund the account.  As soon as the account is enabled to trade, the first thing they do is place a trade.    I would like to propose the first thing you do is make sure you have money management rules in place.    

Money management is the first thing you should master when you do any type of trading.  The money management rules are your safety net to help you avoid blowing up the account.  The worst thing that could happen to you is that you lose your capital and canít trade anymore.   When I was younger, one of my trading instructors, Dr. Alexander Elder, told me that there are two types or threats we should watch out for: sharks and piranhas.     

The shark threat is that loosing trade that takes out a big chunk of your account.   It is a big painful bite that will severely damage your account.  It not also damages you psychologically.   An example of a shark is a 70% loss on a trade.   This could really damage your account if that trade represented 50% of your account.   Just imagine whipping out 35% of you equity in one trade.   That is a real shark bite.

The piranha threat is what happens when you have a sequence of multiple small losses that end up overwhelming you and damaging your account.   Have you seen the videos of how piranhas kill a cow in the amazons?   They take a lot of small bites and end up eating the cow.   Same with your trading account, if you have a lot of small losses your account will blow up and die.  

It is very important that your account prevail against your bad trades, piranhas or sharks.    When managing my fund, we have very specific money management rules.   First, never risk more than 2% of capital on any single trade.   Second, if in any single month the account loses more than 6% we stop trading for the rest of the month.  

The first rule, never risk more than 2% on any single trade, is to protect against the shark attacks.   If you keep your risk to 2% on one trade your account will be able to survive if you get a big loss on the trade.  Yes, losing 2% is not nice, but it wonít kill your account.  In practice, at my fund, we rarely risk 2% on any one trade.  Most of the time, we risk 1% or less on any one trade.   We only risk 2% on a trade when the trade is one of those trades you see once in a blue moon.

The second rule, stop trading when you have lost 6% in a single month, is to protect against piranha attacks.    When you have multiple trades go bad in a row and things are going against you, something has gone or is going wrong.    You should stop and re-asses your trading strategies.  Maybe your setups are wrong.  Maybe the environment changed and you didnít notice.   Maybe you are stressed and not making good decisions.   The point is that if you are down 6% in a month, stop trading for the month and start fresh the following month.    Some of my investors ask me why 6%.   This is an arbitrary number. Your number could be 4%, 5%, 6%, 7% or any number you can live with.   My reasoning is that since the fund is designed to earn on average 3% per month, Iím willing to lose the equivalent of a two months (or 6%) of gains.   The key is to not let the piranhas kill you.   You need to be able to trade another day.

Remember; donít let bad trades kill account.   Make sure you have strict money management rules in place and abide by them.   When you do this, you will be a step closer to making money.

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