advanced money management techniques

Advanced Money Management Techniques

The more seasoned traders no doubt realize the saving and conquering power of using money management techniques to leverage his or her chances of obtaining a winning trade. Those not so experienced, may at times be perplexed at just how a few bad trades can seem to destroy their hard earned profits for the month.

While money management is not the Holy Grail to trading success, it certainly is an integral part and I’m about to share one of my best money management strategies with you. Now if you don’t have a sound trading system, then this technique, nor any other will help you.

On the other hand, if you have a sound trading strategy, then this technique is certainly going to improve your bottom line, and if you have one that is “so-so”, this technique might even make the difference between success and failure.

How Does It Work?

It works by evenly distributing the risk among all of your trades. Why is this so important? Perhaps you have heard of the 80/20 rule in business, that is that 80% of your profits come from 20% efforts. This is a common phenomenon. The business I used to be in got roughly 80% of their profits from 20% of their clients, and trading is similar. You never know which trades will turn out to be the “slam dunks” and which ones will turn out an average profit.

Losses can work in the same manner, that is you don’t know which ones will be the losing ones, and if you don’t control them, you won’t know how much they will lose either.

So by controlling our loss limit and especially by making them all have the same limit as respects our account equity, the scales of wins and losses are tipped in our favor. Now the only uncontrolled factor is the profit potential, and of course we don't want a limit on that..

How do you limit every loss to the same amount with respect to your account equity when every trade occurs at a different price, has a different entry and stop loss point? To make it easy, I’ve put the formula into a calculator for you. You just fill in the yellow boxes and it will recommend the number of shares to buy of a given stock in order to keep the same amount of your account at risk the same for all of your trades. Here is what it looks like;

position size

Here is what to put in the boxes;

Account Equity: The total cash in your trading account. This is not to be confused with your total buying power if you have a margin account.

% Risk Limit: This is the total amount of your trading account you want to be at risk for any one trade. How much do you enter? Well consider this; If you risk 1% of your total trading account on every trade and lose every trade, you would have to make 70 consecutive trades to lose half of your account. If you risk 2%, you would make 36 trades to lose half, and at 3% you would have to make 24 consecutive losing trades to lose one half of your account. So it depends upon how cautious you want to be.

Trade Entry Risk: This is the amount of risk that you take on by opening a position. It is calculated by the percent difference between your entry and stop loss point. For example, if you enter at $39.52 and your stop loss is $38.61, then your risk is 2.3% ( 39.52 – 38.61 = 0.91 / 39.52 = 2.3% ).

Commission: This is your total commission for a round trip (buy and sell).

Equity Price: This is your entry price (the price you plan to buy the stock at).

That’s all there is to it. The green boxes are protected and provide you with the results of your entries. If you even out your positions like this, you'll never see a "Titanic" trade, one that takes a big chunk of your account down with it.

If you want to see how this can help you, pull out your completed trades for a prior month and on paper adjust the position sizes according to this calculator and see what the difference in your bottom line would have been. You might be surprised at the results.

You can download a copy of this calculator by right clicking here and selecting "Save Target As".

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