Money Management – Explanatory Notes

Table of Contents

• Money Management – Explanatory Notes
  • Individual Trade Risk:
  • Session Money Management: “Session Draw-down Risk”
  • Business Money Management: “Business Draw-down Risk”
  • A Graduated Approach to Increasing Size: “Increased Size Risk”
  • Income to Maintain Lifestyle: “Insufficient Income Risk”
• Additional Considerations – Higher Timeframe / Multiple Markets
• Money Management – Wrap Up

Money Management – Explanatory Notes

Below is Money Management – Explanatory Notes for Money Management – Trading Plan Inclusion.

Individual Trade Risk:

• Treatments must be applied to our trading plan to ensure that no single loss can threaten the survival of our trading business.
• Individual trade risk will be managed through the use of stop-loss orders and position sizing, such that individual trade risk will not exceed 1% of equity.
• Most educators recommend varying levels between 1% and 5%, with the majority recommending 2%.
  • We recommend 1% maximum.
  • 2% is too great in my opinion during the learning process.
  • If you have five full-size losses in a row, which will happen while learning, you have lost 10% of your account.
  • In my experience, this is too great a loss over too short a period of time for new traders, who still have not developed trust in their strategy or themselves.
• Experiment with greater risk if you wish, AFTER having proven consistent profitability.
• For NOW, Individual trade risk must be no greater than 1%.
• Note: When trading in 2 part positions, the maximum risk per part must therefore be 0.5%.
• Under NO circumstances will you allow a trade to continue past its stop loss point.
• Price hitting your stop means that either your trade idea was wrong or your timing was wrong.
• Either way, you need to be out in order to contain any risk.
• One final word of warning!
  • Please note that limiting risk through the use of stop losses does not guarantee the risk is limited to that amount.
  • In most markets a stop loss order when triggered generates a market order designed to exit you from your position.
  • In Intraday conditions of extreme market panic there may not be any orders taking the opposite side of your market order.
  • Significant slippage can occur. A lot of traders lost a lot of money.
  • Be familiar with exactly how your broker executes and manages their orders. And accept that there will always be risk in the markets.
  • Hence the often provided disclaimer that you should only ever trade with money you can afford to entirely lose.
• That being said, the 1% individual trade risk will provide a significant buffer of safety should you find yourself positioned against one of these extremely rare market events.

Session Money Management: “Session Draw-down Risk”

• Treatments must be applied to our trading plan to ensure that no 1 trading session draw-down can threaten the survival of our trading business.
  • While our 1% maximum individual trade risk will assist here in slowing any rate of draw-down, our session survival can still be threatened through poor personal management.
  • Such examples would include over-trading or revenge trading; desperately continuing to trade when in draw-down in order to salvage something out of the session.
  • This will rarely ever work. Quite likely the initial draw-down is a result of poor market read or negative psychological influences.
  • Our attempts to recover the session will be even further impacted by worse market read and psychological influences, as our perceptual abilities and decision making are impaired through fear of loss.
• I recommend implementing a "timeout" at 2% session draw-down.
  • This is fairly small amount, but two full-size losses are a warning that perhaps you are not in sync with the market, or there are some external or internal distracters impacting your ability to execute your plan.
  • Take a short break; then review the session so far.
  • Continue only if you can confirm that the trades were appropriately selected, entered and managed in accordance with your plan; or if you identify errors and correct them.
  • Note that 2% draw-down does not just mean 2 stop-outs.
  • With an active trade management process, many stops will occur with reduced loss.
  • It may take you 2, 3, 4, 5 or even more trades to hit a 2% session draw-down.
• We recommend implementing a 3% session draw-down compulsory stop.
  • Something is not right. Walk away. Review at a later time.
  • Capital has been saved to allow you to continue next session.
• The figures for 2% session timeout and 3% session stop are of course just recommended.
• I acknowledge however that they are very tight.
• If you are comfortable with more risk then you can increase these limits.
• We would recommend waiting till consistent profitability is proven first.
• Please though, not more than 3% session timeout and 5% session stop.
• Take some time out to reassess and start fresh next session.
• Your session P&L must operate with a session trailing stop.
  • Do not get off to a great start in this session and then give back all your profits as you trade your way back down to your maximum session stop.
  • Like we do with individual trades, we will implement a session trailing stop.
  • We recommend the same parameters we use for initial stops. Trail your session timeout 2%. Trail your session stop 3%.

Let’s look at an example:

• Equity Balance ₹20,000
• Individual trade risk: ₹200 (1%)
• (Note. Trading two parts will require max ₹100 risk per part)
• Trading session timeout:
• Initial timeout at ₹400 (2%), trailing ₹400 below session equity highs.
• Trading session stop:
• Initial stop ₹600 (3%), trailing ₹600 below Intraday session equity highs.

Business Money Management: “Business Draw-down Risk”

• Treatments must be applied to our trading plan to ensure that we stop trading at a certain level of draw-down and halt any further erosion of our balance.
• We recommend a stop at 20% draw-down.
  • At this point, something is not going right.
  • If you want more, then at the absolute most do not go beyond 30% draw-down.
  • Beyond this it becomes more difficult to regain the losses.
• Take some time out to again study this document. Review your trading performance with the benefit of hindsight and return to simulation trading, until consistent profitability is again proven.
• New traders, with small account balances, should use this time out of the markets to replenish their account from other income sources, and should not start trading live again until the account balance is back to its original level.

A Graduated Approach to Increasing Size: “Increased Size Risk”

• Size can only be increased as allowed by our percentage risk rule.
• As the number of contracts traded increases, you will reach levels beyond which the rupee/dollar risk is psychologically more and more difficult to accept.
• This will act as a source of fear to impact upon your trading results.
• We will therefore implement a graduated approach to increasing size.
• Success at the current size must be proven via at least one month of profitable trading.
• All size increases must be proven in a simulation environment first.
• My preference is to see a profitable week, before returning to the live environment.
• This may be done via market replay out of hours, in order to speed up the process.
• If a session stop is hit while live trading, you should consider the need to return to the previous size and/or the sim environment.
• If 2 session stops are hit, then you must return to the previous size.

Income to Maintain Lifestyle: “Insufficient Income Risk”

• The timeframe to consistent profitability is unknown; varying for each individual.

• So our financial survival plan needs to last as long as is necessary for us to achieve this goal.

• Too many books offer the suggestion of saving sufficient funds to allow you to survive for at least 12 months of live trading.

• This implies that 12 months will be sufficient time to achieve profitability.

  • Rubbish.

• What if it takes you 13 months?

• What if it takes you 2 years?

• A better plan is to ensure financial survival for as long as is necessary to achieve your end goal.

• Until you have achieved consistent profitability, any funds withdrawn from your trading account to fund lifestyle expenses place your trading business at risk.

• A wiser plan is to therefore structure yourself such that you do not require any trading profits for lifestyle.

• If sufficient alternate income streams are currently available, such as through your spouse’s income and investment or business income, then you are free to trade full-time while developing your skills.

• If sufficient alternate income streams are NOT available, and trading has not yet developed to a level of consistent profitability such that profits allow both capital growth and withdrawal,

• then you cannot yet trade full-time.

• It may not seem fair, but the reality is what it is. You need to:

  • Continue working in order to support your family and lifestyle.
  • Identify means of developing as a trader, around your work and life.
  • While this is easier said than done, it can be achieved.

• Consider options to limit your trading time to a maximum of 2-3 hours per day, such as via longer timeframes (e.g. daily charts), or day-trading only the opening session of a market or the open of your favorite commodity contract. With markets open 13 hours a day, there will be something available at a time to suit you.

Additional Considerations – Higher Timeframe / Multiple Markets

Higher timeframe traders will usually have multiple positions open at one time. This incurs an additional risk not faced by short timeframe day-traders such as myself – multiple position risk; an unexpected news event or market shock which stops out all positions at once.

• Multiple position exposure must be limited to no more than 3%.
• This does not necessarily mean you limit your portfolio to only 3 positions. You may wish to risk six positions at 0.5% risk per trade. Alternatively you may be willing to add additional positions as current positions move their stop to break-even or beyond, accepting that there is no longer an account draw-down risk with these trades.
• In addition, take care to ensure that multiple positions are not in highly-correlated markets. Unless you actively monitor market correlations and identify suitable conditions for these trades, it’s best to just avoid highly correlated markets.

An additional consideration is the need to redefine the term “session”. In previous discussion, session timeout and stop limits related to my own day-trading, referring to one trading period, or one day.

For longer timeframe traders this won’t be applicable, as your trades will often extend greater than one day. Redefine a trading session to whatever is applicable to your circumstances.

For example, you may wish to define timeout and stop criteria per week.

Money Management – Wrap Up

Some final points to wrap up money management…

There’s a great difference between the session stop level of 3% and the business stop level of 20%. Some of you may wish to implement an intermediate level, such as a Weekly or Monthly percentages for timeout and stop. I don’t, as I’m typically aware of the fact that something is wrong and am able to conduct a review anyway, despite not mandating any stop levels. However it may be something you wish to consider.

And most importantly… I know some of you will not have sufficient funds to trade with a maximum of 1% risk. If that’s the case, then rather than accepting additional risk, I recommend you continue with simulation trading only while saving additional capital, or find a market or timeframe which allows this level of risk.

Money management can be quite complex if you wish it to be so. My preference is to make it as simple as possible. Avoid all mathematical models such as “Optimal f” or the “Kelly Criterion”. Stick to a simple approach.

The focus for most of you will not be capital growth, but capital preservation during the learning phase. So make it simple and make it safe. Minimize the potential for career-ending drawdown. Stick to a low percent risk model.

Once consistently profitable, if you wish to increase risk in search of higher gains then by all means do some research on alternate money management strategies. I don’t recommend it though. For me, simplicity is always the best.