3 Keys to Money Management

All of your trading, buying and selling, revolves around money. Therefore money management is about managing your business and maximizing your stock market trading profits.

There are five key elements to good trading money management:

1. Trading Capital

For every winner in futures trading there is a loser, this being so, you should consider trading as a battle and to fight the battle you need ammunition. Your trading capital (bank of money) is the ammunition you need to fight, if you run out of ammunition the war is over. You should keep your trading capital completely separate from living expenses, don’t trade with the mortgage money. Only trade with money you can afford to lose and don’t borrow money to trade as some people did at the height of the Internet bubble.

It is much harder to make money when you have to, if you cannot afford to lose it, this will only add pressure to your trading and you will make errors. If your funds are limited, think about having a garage sale of those household items, toys and gadgets you have but never use, or auction them on Ebay. The minimum you need to open a futures trading account is commonly $2,000 – some brokers will accept less but it is easier to lose your ammunition and the ability to fight/trade.

Starting with $2,000 will allow you to trade two $5 mini-Dow contracts, this is a 200:1 capital to stake ratio and should not be lowered. In fact you should only trade one contract to begin with and have one in reserve.

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The preservation of capital is of the utmost importance.

2. Win/Lose Ratio

To manage your trading properly it is absolutely necessary to document each and every one of your trades. If you don’t and you are losing you will not know where and why you are losing and what you need to do to make things profitable. Likewise if you are winning you will not know if you are attaining the best profits.

Nobody wins all of the time, the win/lose ratio is usually expressed as a percentage (e.g. if you win 66 trades out of every 100 then you will have a win% of 66% and a losing% of 34%. This expressed as a ratio is 66/34 = 1.941:1.) You do not have to make 100 trades to calculate this; all that you need to know is the number of winning trades and the total number of trades made.

  • For example you have made 37 trades in total and you have won on 21 occasions, therefore you must have 16 losers (37-21). The win/lose ratio is 21/16 = 1.3125:1, the win% is 21/37 = 56.76%. The losing% is 16/37 = 43.24%.

It is quite possible to make a profit even if you have more losing trade than winning trades and many swing trading methods work on this principle having say 20 wins to 40 losers = 20/40 = 0.5:1 ratio. Anything less than 1:1 or 50% win% and you will have more losers than winners. Many traders have a problem trading a system with a low percentage of winning trades, even though it wins in the long run psychologically they would find a long run of losers very difficult to cope with.

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To calculate the expectancy, (the amount we can expect to gain per trade) we need another set of figures that we will look at next.

3. Risk/Reward Ratio

There are many ways to make money in the stock market, it depends on your trading style, no “one” method is right for everyone. Many traders say that they only trade with a 3:1 risk/reward ratio (i.e. they are going to risk $1 and attempt to win $3.) These stock trading systems usually have more losing than winning trades, they are often profitable over the long term but can have a series of consecutive losses.

  • Calculating reward is simple it is just the average number of points won per trade, so if you have made 37 trades, of which 21 won a total of 252 points your average win (reward) is 252/21 = 12 points. Risk is just the average number of points lost, over the same 37 trades you must have had 16 losers and had a total loss of 128 points your average loss (risk) per trade is 128/16 = 8 points. The risk/reward ratio is simply 8:12 or 1:1.5.

Combining the trading money management keys 2 and 3 together, we can calculate how much we can expect to make for every trade on average over the long term. If you end up with a plus figure you will be winning and making profits, should you end up with a minus figure you will be losing.

You may say that you do not need to do any calculations to see if you are losing, you already know this because your account balance is down. The points of this exercise is that if you do the two calculations above you will find out where you are going wrong, and by playing around with the expectancy calculations below you do various “what if” scenarios to see what can be done to make things better.

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This also applies to profitable trading; there is always scope for improvement.

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