Money management tells you “how many?” or “how much?” to trade. How much risk should you be willing to take? This is the most crucial concern a trader faces; it determines your risk and profit and is often a technique that is neglected by traders.
Like all aspects of trading, there are no hard and fast money management rules. Strict control of trading capital is possible, however, with the application of basic common sense principles.
What are my trading goals?
How much money am 1 prepared to risk on individual trades and how much of overall equity will be put on the line?
How and where will 1 set stop loss orders?
What is an acceptable risk/reward ratio?
What markets will 1 trade to diversify my portfolio?
Successful futures traders work according to probabilities, aiming to win more on average than they lose. Whatever the approach, money management reduces the need to find the perfect trading system.
There are numerous approaches to money management. Some simple techniques include:
Pyramiding (inverted and conventional and reflecting)
Pyramiding generally involves adding or compounding contracts during the length of a profitable trade.
Inverted pyramiding involves commitments of equal (or larger) positions being added as the trade progresses,
Conventional pyramiding involves adding half of the prior position as the market moves in the traders anticipated direction,
And reflecting pyramiding involves closing positions when an average profit is reached.
Fixed percentage determines the position size as a percentage of risk capital by using a mathematical formula. It is calculated by dividing the largest loss by the percentage of capital risked.
The z score technique enables traders to determine what system/trading profile type they belong to, and whether to increase, decrease or hold the position size of a trade on any given trade. A negative z score is associated with winners followed by winners, and visa versa, losers followed by losers. A positive z score is associated with a random approach of winning to losing trades.
The optimal f technique enables traders to determine what amount to allocate on any given trade based on their risk capital size and largest loss. For example, if optimal f is calculated at 0.65 and the largest loss is $400, then the number of contracts to trade is two on a $5,000 account. Optimal f is aggressive and drawdowns can be volatile but the returns can be large.
Effective money management allows a trader to juggle the risks associated with futures markets and maintain the right balance between winning and losing trades. Without money management, there is a risk of possible lower returns and increased risk, and more importantly money management gives you the key to becoming a long-term trader.
Mathematics of Money Management, by Ralph Vince
New Commodity Trading Systems Methods, by Perry Kaufman
Technical Analysis of Stocks, Options and Futures, by Williarn F Eng
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