Simple money management wins over time

December 31, 2011 06:00 PM

The difference between a successful trader and a losing trader has a lot less to do with the successful trader’s ability to pick winners than you might think. All traders are going to experience losers and lots of them. It’s a fact of the business.

A winner, however, embraces the understanding that a large element of any one trade is randomness — in effect, any given trade is, on some level, a gamble. Losing trades are inevitable, and the winner takes that inevitability into account. Many longtime successful managers have done it with a winning percentage just above 50% and even the best traders are right only about 60% of the time.

It isn’t necessary to achieve that success rate to profit in the long-term, though. It isn’t even necessary to be 50% right (see "Win some, lose some," below). The depicted scenario assumes a 40% win rate — in other words, eight winning trades out of 20. The key to making a 40% win rate profitable is to structure your trades so that your winners profit at least twice as much as your losers lose — and that your initial stake can withstand the inevitable string of losses.

Look no further than recent headlines to illustrate this. Numerous ill-informed analysts have made the point that former MF Global head Jon Corzine could end up being correct on his positions in foreign bonds. No, no, no. When you take a leveraged position, you are not simply speculating on the direction of the market, you also are making a market timing decision and a position on volatility. You limit how far the market can go against you before you must bail.

Consider the assumptions in our table. Our hypothetical winning trades yield a profit of $2,000, and the losing trades lose half of that amount. Of particular significance is that even though 60% of the trades are losers, after 20 trades the overall balance is a positive $4,000. However, at one point the overall balance was $4,000 below water.

Page 1 of 4
About the Author

Joseph Stuber began his career in 1972 as a research analyst. He is an author and lifelong student of risk and risk management.