Money
Management
Learn
to trade 
Money Management
Why is it important? Well, we are in the business of making
money, and in order to make money we have to learn how to
manage it. Ironically, this is one of the most overlooked
areas in trading. Many traders are just anxious to get right
into trading with no regards to their total account size.
They simply determine how much they can stomach to lose in
a single trade and hit the “trade” button. There’s
a term for this type of investing….it’s called
GAMBLING!
When you trade without money management rules, you are in
fact gambling. You are not looking at the long term return
on your investment. Instead you are only looking for that
“jackpot”. Money ma nagement rules will not only
protect us, but they will make us very profitable in the long
run. If you don’t believe me, and you think that “gambling”
is the way to get rich, then consider this example:
People go to Las Vegas all the time to gamble their money
in hopes to win a big jackpot, and in fact, many people do
win. So how in the world, are casino’s still making
money if many individuals are winning jackpots? The answer
is that while even though people win jackpots, in the long
run, casino’s are still profitable because they rake
in more money from the people that don’t win. That is
where the term “the house always wins” comes from.
The truth is that casinos are just very rich statisticians.
They know that in the long run, they will be the ones making
the money—not the gamblers. Even if Joe Schmoe wins
$100,000 jackpot in a slot machine, the casinos know that
there will be 100 more gamblers who WON’T win that jackpot
and the money will go right back in their pockets
This is a classic example of how statisticians make money
over gamblers. Even though both lose money, the statistician,
or casino in this case, knows how to control their losses.
Essentially, this is how money management works. If you learn
how to control your losses, you will have a chance at being
profitable.
You want to be the rich statistician…NOT the gambler
because in the long run, you want to “always be the
winner.”
So how do you become this rich statistician instead of a
loser?
Drawdown and Maximum Drawdown?
So we know that money management will make us money in the
long run, but now I’d like to show you the other side
of things. What would happen if you didn’t use money
management rules? Consider this example:
Let’s say you have a $100,000 and you lose $50,000.
What percentage of your account have you lost? The answer
is 50%. Simple enough. Now, what percentage of that $50,000
do you have to make in order to get back to your original
$100,000? It’s not 50%--you’d have to make back
100% of your $50,000 to get back to your original $100,000.
This is called drawdown. For this example, we would’ve
had a 50% drawdown.
The point of that little illustration is that it is very
easy to lose money and a lot harder to make it back. I know
you’re saying to yourself, “I’m not going
to lose 50% of my account in one trade.” Well I would
certainly hope not!
However, what if you lost 3, 4, or even 10 trades in a row?
That couldn’t possibly happen to you, right? (sarcasm
used) You have a trading system that wins 70% of the time,
so there is NO way you could lose 10 trades in a row. (even
more sarcasm used) Well while you may have a good system,
consider this example:
In trading, we are always looking for an edge. That is the
whole reason why traders develop systems. A trading system
that is 70% profitable sounds like a very good edge to have.
But just because your trading system is 70% profitable, does
that mean for every 100 trades you make, you will win 7 out
of every 10?
Not necessarily! How do you know which 70 out of those 100
trades will be winners? The answer is that you don’t.
You could lose the first 30 trades in a row and win the remaining
70. That would still give you a 70% profitable system, but
you have to ask yourself, “Would you still be in the
game if you lost 30 trades in a row?”
This is why money management is so important. No matter what
system you use, you will eventually have a losing streak.
Even professional poker players who make their living through
poker go through horrible losing streaks, and yet they still
end up profitable.
The reason is that the good poker players practice money
management because they know that they will not win every
tournament they play. Instead, they only risk a small percentage
of their total bankroll so that they can survive those losing
streaks.
This is what you must do as a trader. Only risk a small percentage
of your “trading bankroll” so that you can survive
your losing streaks. Remember that if you practice strict
money management rules, you will become the casino and in
the long run, “you will always win.”
Let me illustrate what happens when you use proper money
management and when you don't...
Here is a little illustration that will show you the difference
between risking a small percentage of your capital compared
to risking a higher percentage.
You can see that there is a big difference between risking
2% of your account compared to risking 10% of your account
on a single trade. If you happened to go through a losing
streak and lost only 19 trades in a row, you would’ve
went from starting with $20,000 to having only $3,002 left
if you risked 10% on each trade. You would’ve lost over
85% of your account! If you risked only 2% you would’ve
still had $13,903 which is only a 30% loss of your total account.
Of course, the last thing we want to do is lose 19 trades
in a row, but even if you only lost 5 trades in a row, look
at the difference between risking 2% and 10%. If you risked
2% you would still have $18,447. If you risked 10% you would
only have $13,122. That’s less than what you would’ve
had even if you lost all 19 trades and risked only 2% of your
account!
The point of this illustration is that you want to setup
your money management rules so that when you do have a drawdown
period (losing streak) you will still have enough capital
to stay in the game. Can you imagine if you lost 85% of your
account? You would have to make 566% on what you are left
with in order to get back to breakeven. Trust me, you do NOT
want to be in that position. In fact, here is a chart that
will illustrate what percentage you would have to make to
breakeven if you were to lose a certain percentage of your
account.
You can see that the more you lose, the harder it is to make
it back to your original account size. This is all the more
reason that you should do everything you can to protect your
account.
So by now, I hope you have gotten it drilled in your head
that you should only risk a small percentage of your account
in each trade so that you can survive your losing streaks
and also to avoid a large drawdown in your account. Remember,
you want to be the casino…NOT the gambler!
Another way you can increase your chances of profitability
is to trade when you have the potential to make 3 times more
than you are risking. If you give yourself a 3:1 reward/risk
ratio, you have a significantly greater chance of ending up
profitable in the long run. Take a look at this chart as an
example:
In this example, you can see that even if you only won 50%
of your trades, you would still make a profit of $10,000.
Just remember that whenever you trade with a good risk to
reward ratio, your chances of being profitable are much greater
even if you have a lower win percentage.
Summary:
Be the casino, not the gambler!
Remember, casinos are just very rich statisticians!
Drawdown is a reality and WILL
happen to you at some point. The less you risk in a trade,
the less your maximum drawdown will be.
The more you lose in your account,
the harder it is to make it back to breakeven.
Trade only a small percentage of your
account. The smaller the better. 3% or less is recommended.
It is desirable to trade when you
have a high risk to reward ratio. The higher the ratio, the
less you have to be right
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