Money Management: The Backbone of a Successful Trading Method

“Even a poor trading system could make money with good money management.”

-Jack D Schwager, The Little Book of Market Wizards: Lessons from the Greatest Traders

We all have either traded or wish to trade in various asset classes like Equity, Commodities, Forex, Bonds, etc. and keep looking for a successful trading method. A Successful Trading Method is the one which makes money in the medium to long term time frame. Ironically most of the traders find it really difficult to make money in the longer term even if they are successful in the shorter term. People could be plain lucky to have made money occasionally or they may have made money on some specific tips that they got ‘in time’ and which went right also, which is more often not the case, but if they continue without ‘a plan’ they would lose money for sure in the medium to long term. This plan is nothing but a ‘Trading Policy’ with the customised ‘Money Management Techniques’ incorporated into it. All those who are there to make money, need it. Only those who are there for thrill, gambling or pure fun, etc. can afford to ignore it and trade for their chosen reasons without any plan. They will get everything but the money. Please remember if you fail to plan, you are planning to fail, very clichéd but very relevant also for Trading.

Definition: Money management is a strategy for increasing or decreasing the position size to limit risk while achieving the greatest growth possible from a trading account. It focuses on both the risk and reward factors on your account. It allows you to leverage the account while balancing risk. Money management can be used when trading any market as it is focused on one thing alone, and that is account performance.

There are 2 basic approaches to money management, Martingale (as per the dictionary a noun which means a strap or set of straps running from the noseband or reins to the girth of a horse, used to prevent the horse from raising its head too high.), and Anti-martingale.

Martingale methods increase the position size with losses. As the account is in a losing streak the trader will double the position size in order to recoup all the losses and make a little profit. The idea is that a losing streak won’t last forever and once it ends the account will be profitable. However, in reality, losing streaks can go on and on and on, and the trader will be risking everything just to get back to breakeven. Psychologically also it is almost impossible to implement. Martingale methods create geometric risk, not growth. In my view the Martingale method is a sure shot recipe for disaster though there are people who still make money with the help of it. These are mostly the people with very deep pockets and the money made ultimately is nothing in proportion to what they could have made with the Anti-martingale methods and also not commensurate with the money that they already have with them. Are you really going to risk blowing out your account on one trade just to make up for all the earlier losses and make a small profit? Please remember that “the market can remain insane longer than you remain solvent”.

Anti-martingale methods are just the opposite. The position size increases with wins and decreases with losses. All the various methods discussed below are the Anti-martingale ones.

1.   The 2% Rule Method

The 2% Rule is an anti-martingale money management method that is based on your account size.

Risk per Trade = Account Balance X 2%

To apply the 2% rule, you can use a position size calculator that is very easy to use that will spit out your position size for each trade with just a few clicks.

This is a conservative approach that focuses on limiting risk and is a good method if you are a new trader just starting out. It will keep you in the game while you build your confidence and valuable experience. However, it is not really growth-orientated and difficult to use in some leveraged markets.

2.   Fixed fractional Method

One fixed fractional method commonly used is to trade 1 contract for each X amount of money in the account. X can be set to be a large or small number.

X = INR 10,000; If Account Balance = INR 20,000, then Position Size = 2 contracts

To apply this method you would begin trading 2 contracts, and once your account reached INR 30,000, then you increase your position size to 3 contracts, and so on.

When X is too large then this method is risk-averse but growth is slow. When X is too small then growth is quick but there is a possibility of catastrophic loss. One can adjust the X as per his/her risk profile.

 3.   Optimal f method

This method was developed by Ralph Vince, and it is a mathematical model to determine ‘f’ which stands for fraction. The method solves for the optimum fraction from a given set of trades that will produce more returns than any other fraction. This method has great growth potential but susceptible to catastrophic risks. While Vince’s work is thought provoking, it is also a bit theoretical and not applicable to real world trading. The problem with optimal f is that the calculation is dependent on the largest trading loss, and you can never know when that is until it happens. Overall not useful for we small traders.

4.   Secure f Method

Secure f is a safer version of the Optimal f method. The risks have become manageable but at the expense of geometric growth. Overall, the theory behind Optimal f and Secure f makes a lot of sense, but we aren’t sure of the practical application, except maybe for the World Trading Competition where Larry Williams became the all-time winner turning $10k into $1.1 million in just 1 year.

5.   Fixed Ratio Method

The Fixed Ratio Money Management Method was developed by Ryan Jones and presented in “The Trading Game”. It is a very different approach to money management.

Fixed Ratio focuses on profits made rather than the size of the account. There is just one variable called the “Delta”.

Delta = INR 1,000; Position size increases when INR 1,000 per contract in profits are made.

The delta is determined by the max drawdown of your trading plan. If your strategy produces large drawdowns, he recommends a delta of 1/2 the max drawdown and equal to or greater than the max drawdown for low drawdown strategies. As long as you have enough capital in your account to cover risk, margin, and some breathing room, it doesn’t matter whether you have INR 10,000 in your account or INR 100,000, the size of your account is not a factor.

Begin trading with 1 contract and once you’ve made INR 1,000 in profits, increase the position size to 2 contracts. Since you increase the position size with every INR 1,000 made per contract, increase the position to 3 contracts once you’ve made INR 2,000 in profits.

This method is great for smaller accounts. The risk on the account peaks at the 4-5 contract level and continually decreases as the account grows. It isn’t optimum for larger accounts, but it is a method that will get you there most efficiently. It provides geometric growth without the catastrophic risk!

Below is a table comparing the growth and risk factors of the different strategies:

Strategy Growth Risk

2 % Rule Slow Low

Fixed Fractional Large X = Slow Low

Small X = Geometric High

Optimal f Geometric High

Secure f Slow Low

Fixed Ratio Geometric Low

Like dieting and working out, Money Management is something that most traders pay lip service to, but few practice in real life. The reason is simple: just like eating healthy and staying fit, money management can seem like a burdensome, unpleasant activity. It forces traders to constantly monitor their positions and to take necessary losses, and few people like to do that. However loss-taking is crucial to long-term trading success. Please have a look at the table below. Note that a Trader would have to earn 100% on his or her capital - a feat accomplished by less than 1% of traders worldwide - just to break even on an account with a 50% loss.

Amount of Capital Lost Amount of Return Necessary to Restore to Original

Caiptal Value (as percentage of the remaining Capital)

25% 33%

50% 100%

75% 400%

90% 1,000%  

Before you decide on the best money management strategy for you, it’s important to ask yourself as to what type of a trader you are. Trading is a very psychological endeavour and as such you need to implement an approach that best fits your personality. If you are a conservative trader who wants lower risk and stable returns you would choose a different method and if you are an aggressive trader willing to accept higher risk for geometric growth you can choose a money management approach that fits your style of trading.

Money management is different from the Risk Management and the Position Sizing. Risk Management addresses the amount of risk you will take on a given trade. Position Sizing addresses the size of the position you will use for the trade. These are ways of implementing Money Management. Money Management will determine whether or not the size should be increasing or decreasing.

Money management is NOT going to turn a bad trader into a good one. It cannot turn a bad strategy into a winning one. If a trader doesn’t have the disciplines required to trade correctly then money management will not work.

Money management will provide geometric growth to your account when correctly trading a strategy with a positive expectancy. A positive expectancy simply means that when you average out all the wins and losses that you make money, you have an edge.

Tips to increase the trading performance

Here are some things that will help you improve your performance that will greatly increase the speed of geometric growth on your account with Money Management.

Write Your Trades Before Initiating

Before you take a position, write it down in a Diary, if possible with the rationale or logic that you have for your preferred view. This will help you in executing it without second thoughts particularly while taking profits (you will not take earlier) and booking losses (you will not wait longer). You can also remove the position earlier, before hitting the Stop Loss or Take Profit, if the logic changes or vanishes and the view becomes unclear again. You can re-enter the market when you again get a signal or clarity, but again after writing it first. A periodic review of the trades will help you immensely in not repeating the mistakes again and again.

 Accept the Risk

In order to be successful, you must truly accept the risks. Many traders say they accept them and then fall apart at the first sign of adverse movement against their position. Thinking in groups of trades instead of each trade will help.

Use real Stop Loss Placement

Anything and everything can 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 and decide to go to battle with a bank. Make it a habit to place the stop losses with the broker, banks or in the electronic trading system.

Have a Positive Reward/ Risk Ratio

Understand your strategy and that there is a trade-off between the reward/risk ratio and your win rate. Going after a larger profit might result in the market not reaching it, too small and you won’t overcome your losses. Aiming for a 2:1 Reward/Risk ratio or better and you will make money even if you are right only 35% of the time. Also, learn to Trail the Stop Loss to cost if the market has moved in your favour considerably.

Understand Market Volatility

Markets fluctuate from high to low and back again. Be aware of the volatility of the market or markets you are trading, and adjust your strategy if needed. Normalizing your position size is not a requirement of money management, but psychologically t is a good idea.

Be Aware of Market Correlation

Market correlation is the positive or negative link between different markets. Knowing which markets are correlated, and when they aren’t, can help you in many ways. If you are trading Gold and you want to buy the AUDUSD, be aware that you are essentially making the same trade as they generally move in the same direction.

Be Adequately Funded

Have enough money in your account so you don’t over-leverage and run the risk of catastrophic loss. Figure out what your risk of ruin is and make sure your money management strategy is appropriate for your account size.

Be Smart When Adding

When you are right about the market direction then adding to your position will greatly improve your performance. However, the stop also has to be trailed suitably. Don’t just pyramid and add extra risk to a good position. Instead, follow your money management strategy for adding positions. Reverse pyramiding is also an option. The longer the trend continues the higher the chance a consolidation or outright trend reversal is near so decreasing your position size will keep most of your profit in your account.

Have No Position

“Day Traders are not daily traders’. You don’t always have to be in the market. I repeat. Staying out of the market is as big a decision as getting in. Money not lost is just as good as profits made. If the market is unclear or your confidence is down, review your results, and identify mistakes you’ve made and try not to repeat them again and again.

Be Psychologically Prepared

Nobody likes to lose money. Unfortunately losing money in a few trades is inevitable. When you are speculating and making decisions with incomplete information you can never be perfect. Please remember that even while learning cycling you fell down many times before you learnt to do it without any efforts. In trading however the risk of losing money in some trades will always be there. You will gradually learn to live with it and make money overall. Have you ever wondered that it is the ‘break’ of the car that helps you to drive your car very fast? Sounds unbelievable? Try driving a car with no breaks. Stop Losses are the breaks of your faster profit making machine (read method).

Conclusion

Money management is more common sense than rocket science. Well, maybe the Optimal f method comes close. The best money management for you will be acceptable when it comes to the drawdowns that can occur, and one that is a good fit for your personality. Know what to expect from your trading plan and choose accordingly.

When people ask how much money they should begin trading with, one seasoned trader says: "Choose a number that will not materially impact your life if you were to lose it completely. Now subdivide that number by five because your first few attempts at trading will most likely end up in blow out." This too is very sage advice, and it is well worth following for anyone considering trading. However, I would like to add, after you have gained some confidence, choose an amount which is large enough to justify your time and efforts.

When should money management be implemented?

Once you have proven that your strategy has an edge and you can trade it consistently, then it is time to add money management.