Money Management Formulas
Survive First, Prosper Later
Money management has two goals: survival and prosperity. The first priority is to survive, then to make small gains consistently and finally to make spectacular gains. Beginners tend to have these priorities reversed. They aimed for spectacular gains over short time frame but never think about long term survival. Professional traders are always more focus on minimising losses than growing equity.
No one could have said it better than Warren Buffett, the world’s greatest investor,
“Be a Risk Averse Investors”
Trading is a business. Like any business, it will need the right amount of cash reserves at the right time in order to profit from the right opportunities. In trading, your equity in your investment account is your life. You lose it, you are out of business.
The market will always be there so long as you have available capital. One thing is guaranteed in trading, that is losses. We look at the different types of losses.
Businessman Risk’s Vs Loss
Businessman’s Risk
Businessman’s risks are risks that are anticipated by the businessman and losses to these kind of risks are expected. Since they would have anticipated to a certain degree the probability of the loss occurring, they could have taken a sound measure. Businessmen treat this particular risk as an expense of the business.
Losses
The difference between a businessman’s risk and a loss is its size relative to the size of your equity. These are losses that threaten your prosperity and survival. And this is the last thing a trader will want to experience.
A business operating in an office building will face the risk of fire occurrence. Any fire will disrupt the business for months. The potential of fire damaging your property and disruption of your business may just put you out of business. This is a loss that you will never want it to happen, don’t you? So businesses will buy insurance to protect themselves against such losses if it happens.
In trading, the insurance for protection against such losses is free. You do not pay premium for it. However, you owe it to yourself and be responsible for the degree of risk you take. You must draw a line between them and never cross it. Drawing that line is a key task of money management.
Over-trading
It is defined by taking on more trades than you are required to which are out of your system rules. This mistake will benefit your broker and not the trader.
Revenge Trading
It is also another form of over-trading. Traders will tend to make a trade immediately after a loss, seeking to recover the loss. This is done just after he made a bad decision, and wanted to remedy the situation by making a ‘reverse’ trade relative to his first trade. Often, he will see the market reverse against him causing a double loss.
Solution
Markets kill traders in one of two ways. If your equity is your life, a market can snap it with a disastrous loss that effectively takes you out of the game. Or it can also kill you slowly and strip your account to the bone.
These two money management rules are designed and served as an ‘insurance’ to protect you from going out of your trading business.
2% Risk Per Trade
It meant that you will never risk more than 2% of your equity in any trade. This is to protect you from a disastrous loss that may put you out of the business. If you adhere strictly to this rule, the most you will lose from any trade will be a maximum 2% of your account equity.
6% Risk Per Month
Whenever the value of your account dips 6% below its closing value at the end of last month, stop trading for the rest of this month. The 6% rule protects you from a series of losing streaks. If you took 2% risk per trade, assuming you have not had any winning trade for the month, you can only lose a maximum of 3 trades before you stop trading for the month.
6% rule encourages you to increase your size when you’re on a winning streak and stop trading early in a losing streak.
Position Sizing
Position sizing answers the question on how much to buy or how much to sell so that I risk a maximum of 2% in a single trade?
Contract Size =
Account Equity X Risk Per Trade / Stop loss in pips / 10
( Contract Size for 1.00 means trading 100,000 of base currency. Assume 4th digit broker )
Example
Buy at $1.5050
Account Size = $10, 000
Risk Per Trade = 1%
Stop Loss in pips = 50 pips
Calculation
Contract size = 10,000 X 0.01 / 50 / 10
= 0.20
You will Buy 0.20 contract size at $1.5050, and your stop loss will be at $1.5000. If this trade was to go against you, the maximum you will lose is $100.
About the Author
By Warren Seah
Warren examines commercial trading systems. He analyzes to uncover good systems which bring in consistent profits in the long term.
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