While the modern trader must develop a number of skills to successfully bring money home from the markets, one of the most important is money management. Obviously, a trading system with a positive expectancy is critical, but without a robust money management strategy our trading accounts are doomed to wither – the losses that come with any trading strategy will eventually overwhelm any profits.

There are a number of approaches to creating a strong money management strategy. Each of them seek to limit the damage done to our accounts by losing trades, while accentuating the benefit from winning trades. Here are the two primary approaches:

1. Purchasing as much of a stock (or option or currency, etc.) as can with a defined percentage of account value. This is popular with portfolio traders; they use some filter to identify a basket of stocks expected to outperform the market, then purchase equal dollar amounts of each. For instance, if their trading system identifies a basket of 10 stocks, the trader will use 10% (100% divided by 10 stocks) of their total account value to purchase each of the stocks. The basket of stocks is typically rebalanced on some regular schedule, whether monthly, quarterly or annually.
2. Risk a specific percentage of account value on any one trade. From this angle, the trader is using a system which defines a point of ‘no mas’ – a firm stop loss. That can be established by identifying support/resistance zones on a chart, or using some statistical model (ATR multiples have become popular with the writings of Van Tharp). However it is determined, the trade is initiated with a particular rationale in mind and the stop loss is the point at which that rationale has failed.

Both of these will produce some losing trades, but hopefully they’ll all be manageable. On the other side of the coin, how do they work to emphasize the benefit of winning trades?

In the case of ‘basket’ trading, two things happen with winning trades which purportedly maximize profits. First, a stock which is moving in the right direction will usually stay in the filtered list for some time (depending on the actual filter being used) – this gives the stock time to run as far as it wants. Second, by rebalancing the portfolio at regular intervals, a stock whose value has grown beyond the its initial portion of the portfolio will have some of that value harvested. For instance, when a winning stock has grown from constituting 10% of the portfolio’s value to 15% or 20% of that overall value, some shares will be sold. Not all shares – the trader wants to keep that upward potential – but enough that a sudden reversal won’t see all those gains flushed away.

In the case of percentage risk model, some mechanism will be in place to have the initial stop-loss follow positive price action. In this way, a strong move in the right direction will produce a high risk/reward profit, while getting the trader out of the trade at the first sign of a reversal.

Of course, there are numerous variations on both angles to creating a money management strategy. Here is one quite simple approach I use with the forex swing trading strategy we discussed in my previous post (these rules are expressed in terms of long trades, but just reverse everything for short trades):

* Determine the number of pips between entry point of the trade and the lowest point of the past two weeks (last two bars)

* Calculate number of lots to purchase which would risk a maximum of 5% of total account value. Enter order to go long that number of lots.

* When the forex swing trade is established, enter a stop loss order 3 or 4 pips below that two bar low

* Continue to trail the stop at progressive two bar lows, letting it move in tandem with the price of the currency as long as it moves in your direction.

Example: a trade has set up which exposes us to 20 pips of risk. If you are trading a $5,000 account, this money management strategy lets us risk up to $250. If you are trading in a standard forex account, each EUR/USD pip represents a $10 loss or gain, so you could enter a long position with a single lot (risking $200) – two or more lots would have you risking too large a portion of your trading account.

This is a very viable money management strategy, and some variant of it is used by many professional traders. If you find it appealing, try it out with paper trading to see if it fits the rest of your trading plan. But DO try it with paper trading first – always test a new element of your plan prior to implementing it.

Recognizing that your money management strategy is critical to your trading success, there are many other vital points to be considered, as well. To receive a free workbook, “How to Make Your Own Trading Plan”, visit my website at http://www.timoroustrader.com/Make_Your_Own_Trading_Plan_Signup.html.

As always, stay timid!

Timothy McCready

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