Trading is the pursuit of profits in the markets. Money management techniques are the methods by which you maximize those profits and keep more of what you made in the first place.
Too many traders focus on setups and entry patterns, casting aside the concept of money management with the mistaken belief that if they enter correctly, then the profits will take care of themselves. Nothing could be further from the truth. Too often, newer traders allow a profitable trade to become a loser, or a profitable day to become a losing one. This is due in part to the lack of a well-defined money management system.
As with entry and exit rules, the money management technique that works for one trader may not for another.
This is true of any trading method or system when the trader has ultimate control over a trade. The nuances of a trader’s psychology and risk tolerance make it entirely unlikely that two traders trading identical systems will have identical profits — and sometimes those differences can be significant.
Regardless of the money management method that works for you, it must be based on a well-defined set of rules. During the trading day, while the markets are moving at light speed, is not the time to question whether or not to hold a trade, take a profit or stop it out. These rules must be defined and created ahead of time. They must be consistent with the global concept of the trading methodology. They must be tested in a real-time environment, so that a trader can rely on them without hesitation while trading.
ANATOMY OF THE METHOD
The make-up of a money management system can be broken down into the following components: full or partial entry, initial stops, profit targets, and trailing stops.
To some extent, choosing the correct money management system comes down to psychology and not mathematics. To demonstrate, we will start by considering the three following money management methods on their objective qualities only:
• All in, all out: enters all contracts at one entry price and exits all contracts at one exit price.
• Scale in, all out: enters a position by building a position around an entry price, by adding on pull backs, and exiting all contracts at a set exit target.
• All in, scale out: enters all contracts at one entry price and scales out of a position by taking partial profits over time.
For consistency, we will assume that in each of the three styles our initial stop on the trade entry is two points. Also, we will assume that the position size is six contracts. That is, six contracts can be entered all at once or a maximum of six can be held, if the position is averaged or scaled in.
“Making a trade” offers a potential trade setup on a one-minute chart of the E-mini S&P 500. The solid horizontal line identifies a multi-day support area where a long trade may be placed. As we can see, thanks to the benefits of hindsight, the support area did offer an excellent price location for initiating this trade. By chance, it also marks a level that would fill the gap open, a favorite trade of many traders.
The trade entry triggers at the support level of 928. As we can see from the chart, this level is tested a few times before it eventually holds and provides a profit to traders trading the long side.
“Comparing styles” (above) looks at this trade using each of the three money management techniques.
As the table shows, the first style entered all contracts and took a full stop for a loss of $600; the second style only entered two contracts based on the scale-in method, so the loss was limited to $200 and the third style entered all six contracts but took a partial 50% exit of three contracts at just one-half point for a slim profit of $75.
From the chart, we can see that the second and third trades are more or less repeats of trade one, in that a pullback greater than our two-point stop follows the initial entry. As many day-traders know, this is unfortunately a common situation. After three losing trades, the first style is down by $1,800, the second style is down by $600 and the third style is up by $225.
The fourth trade turns out to be the opportunity where the various styles tend to stand on their own merits. All three approaches enter long at 928. Although the market ultimately goes to 940, we’ll assume that the trailing stop took out all positions at 938. The results are shown in “Final standings.”
EVALUATING THE STYLES
We can now evaluate the money management styles from two perspectives: financial and psychological.
The profit differential between the three styles is minimal at best. Although the second approach outperforms the worst by $200, we can safely say that styles one and three perform equally from a financial perspective.
In terms of the psychological implications, we can consider these three elements: the willingness to take trade four, the ability to hold the entire trade for 10 points, and the outcome if trade four never materialized.
We have made some bold assumptions in this scenario. The first is that a trader who has just come off of three stop losses in a row would have the tenacity to enter on the same setup a fourth time. The second assumption is that a trader who is carrying a loss on the day has not violated any standing daily stop rule and would be in a position to take the trade.
While the first and second styles stand to earn more, or the same, as the third style, only a trader employing the third style would approach the fourth setup with a winning attitude. Granted, a mild gain of $225 on a six contract basis is slim. If, however, the next trade fails again, as it had in the first three attempts, this trader would again narrowly increase his gains, while traders employing the first two styles would widen their losses.
Likewise, a trader who enters a trade while sitting on a loss for the day is dramatically more likely to bail out early just to recoup his losses. They would be less likely to hold on for the full 10 points. Following three failed trades, many traders are satisfied with a return to break even or locking in a mild gain.
So, while the third style could be criticized for apparently exiting trades too early, this approach offers both a financial and psychological edge that allows the trader to hold the trade for as long as the market is willing to produce.
Of course, if the winning fourth trade never materialized, then the statistics would be far worse for the first and second styles, with each of them sitting on losses of $1,800 and $600, respectively.
The third money management style, as we have discovered, does not at first glance produce the greatest amount of profit based solely on the mathematics; however, it could be argued that it is the only money management setup that produces any profit at all.
In a range-bound day where trade four produces a very small or insignificant rally, a trader using the first or second styles would find themselves without a sufficient move to recover from the prior stops and potentially deepen the loss.
Style three, by contrast, puts the trader in a positive psychological state, and by the time trade four materializes, the trader is sitting on a profit. While the profits taken by partial exits are slim, they are effective at keeping the trader in the right frame of mind for taking advantage of more lucrative opportunities when they appear.
Greg Weitzman is the founder of TheTradingZone.com and has been a full-time trader for 14 years. He can be reached via his Web site.