Money Management Techniques for Traders
I believe money management techniques are essential to long-term success in trading, and this topic is particularly timely given the amount of volatility we’ve seen in many commodity futures markets lately. Moves like we’ve seen in gold in the past few weeks, rising to $720 then breaking substantially (as much as $48 in one day!) makes risk control critical.
I don’t care if your primary approach to trading is fundamental, or technical. No matter which method you use to get in and out of trade, you need rules that determine your risk and reward parameters. Having rules is better than none at all.
By no means do I imply my word is the last on this topic, and I encourage you to seek out more information on this subject so you can establish the right money management techniques to suit your unique situation.
Identifying Basic Money Management Issues
Before you even get into a trade, you should try to determine how much money you can risk given the size of your account and your hoped-for profit objective. You don’t want to overextend yourself and wind up losing all your risk capital, so don’t put $10,000 on one trade if you have a $10,000 account no matter how strong your convictions. No one is 100 percent right all the time, not even the world’s greatest traders.
My rule of thumb is to allocate 5 to 10 percent of your risk capital on any given trade. Keep in mind, the actual dollar amount will vary depending on the futures product you trade, as each has unique margin requirements, contract and tick values. The risk and reward parameters you establish for a copper trade, for example, will be different than for corn. For the same amount of capital, you could trade four or five corn contracts, versus one copper.
You may also want to risk more or less per trade, depending on your trading time frame. If you are a day trader, I feel you should risk less, because you are going to be trading more and want to leave yourself more ammunition so to speak. If you are a swing trader and you trade less often, you can risk a little more. And if you are a position trader with a longer-term trading focus and trade perhaps one to three times a month, you can risk the most. So that’s where the 5 to 10 percent comes in—you might risk 5 percent if you are a day trader, or as much as 10 percent if you are a position trader.
So, let’s use my 5 to 10 percent rule of thumb for an example trade. Keep in mind you must have the necessary margin requirements to trade, which I am not going to go over in detail here. I am going to simply define my risk and reward based on contract values for the purposes of this discussion. Let’s assume I have a $25,000 account and I want to risk 5 percent, or $1,250, on one trade. What contracts can I trade? Well, you need to look at what you can afford to trade. You could trade CME E-mini S&P 500 futures, which cost $50 for each move of one point. So that allows us a market move of about 25 points (what we will risk on a loss) for our $1,250. That means if we are bullish, we’ll place our stop-loss on a 25-point market move lower. If we are bearish, we’ll place our stop-loss on a 25-point move higher.
You probably wouldn’t want to trade the standard CME S&P 500 futures contract, as one point equals $250, and that only allows us a move of five points before getting stopped out of the trade. Not a lot of wiggle room. (Note also, the margin requirement on one contract is more than $19,500, versus just under $4,000 for the E-mini).
Money Risk versus Price Pattern Risk
As you’ve determined how much you’d like to risk based on your account size and suitable contracts, you can also determine more specifically your entry and exit points for a trade based on price patterns. Putting your stop-loss based on losing “X” amount of money would be a strict money-risk approach. You aren’t looking at support and resistance in terms of your money-management strategy.
I am primarily a market technician, and I prefer to use price patterns in conjunction with my money-management approach to help me determine when to get in and out of a trade. I will use support and resistance levels to help me set my risk and reward parameters. Your price pattern risk will come into play when the market doesn’t confirm your analysis based on the charts, and you are stopped out with a loss.
Setting stops based on chart patterns is one method of helping you define your risk, but you can also use options to help define risk. Which should you choose?
Let’s look at an example to help us decide if options might be a useful tool. Say I am a day trader, have a $10,000 account, want to buy a CME E-mini S&P 500 futures contract. I have determined that I will risk $500 on the trade, or 5 percent of my account value. How many points should I target for the market to move before I get out of the trade? As each one-point move in the E-mini S&P is worth $50, I will risk 10 points ($500/$50 = 10). If I’m a swing trader, I can risk a little more. I may use 10 percent, or risk $1,000. So a 20-point decline is what I’ll use for my stop-loss.
The S&P 500 chart below helps illustrate where we might place our buy and sell stops based on support and resistance.
Click image to enlarge
Instead of using a stop, you could buy a put option to help define your risk. If the S&P were at 1250, you could buy a 1240 put, for a move of 10 points. You would buy a put if you are long the underlying futures, or buy a call if you are short the underlying futures. If the futures market fell to 1230, you’d be stopped out of the trade if you had used a straight stop 10 points below your entry. However, if you had used the option, the put would start to climb in value. If the market turned around and climbed to 1340 instead, your put would be worthless. But who cares? The market moved greater than the cost of the put, and the option did its job. Use of an option as a risk management tool is more suitable if you are looking for a greater move in the market over a longer time horizon, and may not want to be as precise in your forecast.
As this is typically the stance of a position or swing trader, it would make sense for you to consider the use of an option if you are either type. You have time working on your side. You can define your costs and your total exposure. But if you are a day trader looking for quick, short moves, and you want to take advantage of noise, I feel the use of a straight stop is preferable.
Stops Based on Support and Resistance
Support and resistance is part of technical analysis, and we can define our risk by looking to these levels in conjunction with our money-management strategy. Let’s use gold as an example. Going back to February and March of 2006, I am looking for a trend line, and support areas, to help define our risk. We want to buy near the support area, and place a stop somewhere below that level. So we may buy at $555 and put a stop at $538. We’ll determine whether these levels are suitable in terms of money risk, based on our account size. Hopefully you can find support points within your 5-10 percent account parameter. You can tweak your entry and stop levels accordingly, but technical analysis helps you pinpoint more specific price levels where you’d like to define your risk and reward levels.
Calculating Risks, Rewards, and Probability Ratios
In my experience, your goal as a trader is not to be right on every trade all the time, but to have a potential profit that’s greater than what you’ve defined as your risk on any given trade. Theoretically, I can have 10 trades, lose 6 and still make money using this approach.
Of course, this scenario assumes perfect market conditions, which aren’t likely to occur in real life. But let’s say for each trade I risk $1,000, and I have six losing trades. I’d lose $6,000. Say I’m a position trader, so I’d set my profit target at $2,000 on each trade, or $8,000. I’ve actually netted $2,000, while only batting four out of 10. This is an example of why I feel it’s important to risk less than you hope to make. If you go into trading with that kind of concept, you can be a successful trader even if you are only correct in your analysis 60 percent of the time. It boils down to good money management skills.
Another rule of thumb is that the ratio between your risk and reward parameters can be smaller if you are a day trader, and greater if you are a swing trader or position trader. If you are a day trader and are in and out of the market quickly and often, you might risk one point to make 1.25 to 1.50 points. So I’d risk $100 to make a $125 - $150 minimum profit. If you are a swing trader and hold a trade perhaps one to five days, you might risk $100 to make $150 to $175 minimum profit. If you are a position trader and hold a trade many days or weeks, and risk $100, you’d be looking to make $200 - $250 minimum profit. Why? Because there is more noise over the longer-term that affects your risk. You want to under-trade as a position trader to absorb that noise.
As mentioned, using technical analysis, I help determine where to enter my trade and what I’d like to define as my risk. I’m going to buy based on my defined support points, and sell based on my defined resistance points, with my stop-loss points below or above those technical points, respectively. So now I’m in the trade, what other factors do I need to think about in my decision to exit the trade?
I have a golden rule in terms of making the decision to get out of a trade, and it doesn’t matter if you are trading based on a technical chart pattern, or are watching fundamentals. As soon as the reasons for entering the trade are no longer valid, as soon as they’ve changed, then you’ve got to get out. If you entered a trade based on your belief the Federal Reserve Board was going to lower interest rates and it instead raised them, you should get out of the trade, even if the market didn’t go against you. Your thought was wrong, and the environment has changed. Or, say you are expecting the market to move through a key technical resistance point, and you place a buy order when it does. Then the market fails and falls below that old resistance area. You get out, even if you feel the market might come back. You are out, cut and dried. That’s discipline in your approach, sticking to your rules. If you can’t exercise discipline over the long haul, you’ll be out of the game.
I’m going to take a look at a daily chart of the September CME S&P 500 futures and apply some of these concepts. Keep in mind the CME E-mini S&P 500 futures contract is worth $50 for each one-point move. Assume I’m a position trader and have a $25,000 account.
I see a Fibonacci retracement on the chart--a big break. In about four weeks, the market moved from 1340 down to below 1240. See the chart below.
Click image to enlarge
Say you want to still get bearish but missed that move. Where do you get short now? I would look to the 38 percent retracement of that move, which comes in around 1270, as indicated on the chart graphic above. To help define my risk, I’ll target a move above that retracement level as my exit point, perhaps in the range of 1275 - 1278. That’s where I’d put my stop. So if I’m short from 1270, I’ll risk eight points up to 1278, and ask myself if that level falls within the bracket of the chart pattern as well as my defined money risk (based on my account size). For an eight point move in the E-mini S&P, I’m risking $400 per contract. If I have a $25,000 account, that’s within my comfortable 5 – 10 price range to risk on one trade. Now, where do I set my profit target? I’ll look at the charts and might target a move down to 1254, near a support or consolidation level I see. If I got short at 1270, I’m defining two-to-one for my risk/reward parameter. If perfect conditions exist, that 16-point move would earn me $800. I’m risking eight points to make 16 points. Of course in the real world, we have factors like slippage, commissions, unexpected market shocks etc. that will affect both your potential profit, and loss. And either could be substantially larger or smaller than you have predetermined under your ideal scenario.
You can look at trend lines, consolidation periods, daily or weekly pivot points. Use any number of technical analysis methods to assist in your decision-making process. In my opinion, the important part of reaching your goals as a trader is to define your rules, establish your risk/reward parameters and be disciplined in your money management techniques.