Trading is a business. As such, traders can borrow proven concepts from the business world to improve their results. Enter the idea of risk allowance.
This approach is adapted from the business concept of having an allowance that is maintained to cover losses inherent in the course of operations (loan defaults, warranty claims, etc.). In trading, however, the term implies an amount allowed (risked) for covering losses inherent in trading. It prevents taking on risk levels that can lead to catastrophic failure.
For traders, this concept can help them with money management in their futures portfolios and can help provide the staying power to be a successful trader.
MANAGE IT
Throughout the years a lot has been written about money management. Some of this advice begins by noting the significance of money management to trading success, but then either fails to discuss the concept further or worse, it digresses into a series of complex mathematical theories and formulas that would intimidate even the most experienced of traders.
Others deal with money management solely as functions of risk management (stop losses) or position sizing (whether you should trade one or 100 contracts). What all of these approaches do, in one form or another, is help you determine how much you should trade.
However, while these are all valuable elements of successful trading plans, they miss the most fundamental points of money management, which are whether you should trade at all in the first place, and how you should manage the money in your account as you trade. A trader needs risk management measures combined with risk allowance.
Before we look at this in more detail, consider two case studies that reflect the mistakes traders make every day.
MONEY MANAGEMENT BASICS
Even the most successful traders make losing trades, so proper money management is the key to success. You need to follow rule one, manage your risk, exposure and losses. That means following rule two: bet small and stay alive.
Looking at our two case studies shows how these guidelines may have prevented blowups. These guidelines would have helped Joe and Tom avoid losing all of their money in the way they risked too much money on individual trades. Because they did not have an appropriate money management technique in place to allow them to withstand a string of losing trades, they were destined to fail, a destiny that was quickly realized.
APPLYING THE RULES
Understanding the first rule and implementing the second is as simple as this: Risk little and get out quick. This is what successful traders mean when they say “Cut your losses and let your profits run.”
Trading is not without risk, but you want that risk to be on profits and not on capital. The end result of this is the trader should focus on developing a winning money management system rather than identifying winning trades. With the appropriate money management system in place, the individual trades will take care of themselves.
Once you understand and accept this, the question moves from how much you should trade to when, and if, you should trade. Implementing a couple of simple money management practices will help you answer this question.
First, you should never trade unless your risk tolerance, risk allowance and account size are compatible with your overall money management strategy. At this point, you might be asking yourself what specifically is a money management strategy? And what it means to have risk tolerance and risk allowance that is compatible with it?
Basically, a money management strategy is a quantified statement of how much you will risk on each trade; in dollar terms it is the risk allowance. A simple set of mathematical formulas explain how this works.
A = Rt / M
Or
Ra = A * M
Where:
A = account size.
Rt = risk tolerance. How much you are willing to risk (lose) on every trade.
Ra = risk allowance. How much you can risk (lose) on every trade.
M = money management strategy. The % of your account that you will allow for loss on any single position.
This is a one-or-the-other situation. It defines where you start with your money management strategy, which is what percentage of your account you will risk (at most) on any single trade. A common figure for traders and money managers that have been successful throughout a long period of time is 3%; however, you can use another figure. There is no universally correct answer.
In the first case, if you want your risk tolerance to equal your risk allowance, you divide the risk tolerance by your money management strategy to determine the minimum account size with which you need to start.
For example, if your money management strategy is 3% and your risk tolerance is $1,500, then your initial account balance should be at least $50,000 ($1,500 / 3%). While this may seem like a lot of money to risk, you need to remember that you would only be risking 3%, at most, on any single trade. And while anything can happen, managing your account in this way will help avoid the disastrous situation of being wiped out, or getting a large margin call that you cannot afford to cover.
In the second scenario, you start with the account size you will open (or already have opened) and proceed from there. Let’s say this is $15,000. You then multiply that figure by your money management strategy (3%, continuing in the same manner as above) and come up with a $450 risk, at maximum, for any single trade ($15,000 * 3%). In this instance, your risk allowance is less than your risk tolerance. In both cases, the amount you risk per trade is defined as your risk allowance. Remember to account for slippage, all your stops will not be filled at your price.
NOW, TO TRADE
After you have aligned your risk allowance with your account size, you then can begin to develop your trading plan. This begins by using your trading strategy (or strategies) to identify markets you want to trade. Your trading strategy should identify specific entry criteria and prices as well as exit criteria including stop and profit targets. Your target entry price minus your target stop price will allow you to calculate the risk required to trade a particular market.
For example, if you want to buy corn at $2.30 per bushel with a stop of $2.08 your risk is 12¢; at $50 per 1¢, that comes to $600 per contract of target risk. Here is where money management comes into play. If the required risk is greater than your risk allowance, you do not make the trade. Here the required risk is $600 and your risk allowance is $450 so you would not make this trade.
You have developed a money management system that is designed to help you survive throughout the long run. The quickest path to ruin in trading is to start breaking the rules because you then open yourself up to trading on emotion rather than on logic, and that is something you should strive to avoid.
If you have a $50,000 account, then this is an acceptable trade as the target risk ($450) is below your risk allowance ($1,500). In this situation you might wish to consider trading two or three contracts, although that is not necessary. Your risk allowance is the maximum you can risk. You are certainly free to trade less than that amount.
Based on the above example, if the corn trade offers a target of $2.54 (24¢ or $900 per contract) and turns out to be a winner, you would have already made about 2%, which is about 20% of the way to a solid annual return. In a $15,000 account, this $900 profit is 6%, or more than half way home.
There is an adage in investing, bulls and bears make money, but pigs get slaughtered. Translated that means: follow the rules, bet small and stay alive. The key to winning, defined as maximizing account growth throughout the long run, is risking little capital and getting solid returns on as many trades as you can. Every once in a while, you might even hit a home run.
By implementing a money management strategy that includes a defined risk allowance, you can avoid catastrophic losses and give yourself the best chance for success throughout the long run.
Jonathan Horvath is president of C-FX Asset Management, a commodity trading advisor in Chicago that offers managed futures, educational and newsletter services. E-mail him at jhorvath@cfxasset.com.
