Seven Deadly Trading Mistakes - Part Three
So far we've looked at how not sticking to a strategy, and not
planning our trading will inevitably lead us to loss. Now I want
to talk about one aspect of planning in more detail - money
management.
You're probably thinking that's a really really boring subject,
but before you decide to skip this article, let me say that
money management isn't just about making sure you survive long
enough to turn a profit, it can also open up whole new trading
opportunities to you. Mistake Number Three - Not Understanding
Money Management
There are two distinct sides to this subject, and for some
unknown reason, most people only ever talk about one of those -
survival - or what I call classic money management. It is hugely
important though, so let's cover that right now.
The idea is simple; firstly, we have a pot of money to trade
with. Secondly, as we have established, losses are a part of
trading and so there will be times when the cash in that pot
decreases instead of increasing. Therefore, it stands to reason
that if we don't manage that cash correctly, it is entirely
possible that we lose it all and can no longer trade.
So the concept of classic money management is to trade in such a
way that our losses do not disproportionally affect our ability
to trade. An example will make this clearer:
Assume we have a starting balance of $5000. We want to ensure
that we can survive in this trading game for at least six months
- long enough to prove our strategy and ability, and to turn a
profit. At its simplest, we could say therefore that the maximum
we would allow ourselves to lose each day is $40. If we hit that
limit, we would stop trading for the day. This would keep us "in
the game" for our six months assuming the worst case scenario of
losing every day.
We could expand this money management strategy to say that if we
lost our maximum limit of $40 a day four days in a row, we
wouldn't trade on the fifth day of the week, and if we lost 3
weeks in a row, we wouldn't trade the last week of the month,
and so forth. If we were losing as badly as that, clearly
something would be wrong either with the strategy or our ability
to execute it and so these enforced breaks would offer a chance
to step back and analyse where we were going wrong.
Assuming a $40 a day maximum loss, it stands to reason that we
could not enter any trade where the possibility for loss was
greater than $40 - to do so would be to expose our account to a
greater loss than is permissible. So our daily limit gives us a
starting point for calculating risk and reward ratios for actual
trading setups.
Knowing beforehand the maximum we can lose in any one day or on
any one trade gives us a huge psychological advantage in our
trading, as well as keeping us in the game for long enough to
allow our strategy to turn a profit.
There is as I mentioned, another side to money management -
position sizing. Many traders will trade fixed position sizes
based on the availability of funds. This is perfectly valid, but
it means that when looking at instruments to trade, they are
inherently limited in what they can trade. Dynamically adjusting
the size of position a trader is willing to take in relation to
the cost of the underlying instrument can open up whole new
trading possibilities.
For a much more detailed expalanation, I refer you to an article
I have previously written on the subject, you can find it here.
Action: In order to give ourselves the best chance of survival
in the market, we must define clear money management rules for
our trading, based on our available capital. Doing so will give
us the added benefits of relieving the psychological pressure
involved in taking losses, and opening up new trading
possibilites that may previously have been thought too risky.
With our strategy, trading plan, and money management taken care
of, we're ready to trade! In the next article we'll look at
another error that too many traders make in their impatience to
earn big profits.