Money Management

A huge amount of column inches have been dedicated to this subject, with a plethora of ideas and concepts being discussed, but for those of you who need a little primer, here follows a brief overview of what it means and why its so important.

The term 'money management' hails from the gambling industry and is all about staying in the game by managing your money. A little example;

How a newbie 'trader' may unknowingly refine his money management strategy - You are keen on a game of roulette- which for the sake of argument is as close to a 50:50 bet as you can get in the Casino. You have worked out that at every spin of the wheel there is a 50% chance of black and a 50% chance of red. Your wife has given you £100 to play with for the afternoon. You wander into the casino and see a number of roulette wheels each with varying minimum stakes, from £100 down to £5. Common sense would suggest that joining a £100 minimum stake table is foolish. If your first 'trade' goes against you, its back to the wife. However if your first trade was a winner and then you moved to the £5 tables, you realise that you would double your funds (and therefore have twice the length of time at the tables). You ponder your first move and decide that risking all on a 50:50 bet doesn't make sense (it doesn't suit your personality). You also feel that heading straight for the £5 tables is a sensible move as you'll be in the game longer and will develop skills as you learn. You've just developed your first money management rule - Avoid the risk of ruin. You also realised what your appetite for risk is - There are some people that would have headed straight for the £100 table and got blown out pretty quickly. These people are gamblers not traders - wild swings in your capital should be avoided at all costs.

You learn as you play - As you settle into the £5 table and play a couple of games, randomly selecting between red and black you note that after a period of time your Win to Loss ratio is about 1:1 - e.g. every winner accompanies a loser. Your account is neither going up or down. You are however being delivered free drinks and so you stay in your chair and play along quite happily for an hour or so. After a while, you notice that occasionally you have a run of winners and run of losers - sometimes 4 in a row. You begin to consider how you can benefit from the winning runs and protect your capital during the losing runs. You decide that after 2 consecutive winners you will increase you bet size to £7.50 and maintain this level until you lose and that after 2 losers you will drop your minimum size to £2.50 (for the sake of argument, the table minimum has been reduced allowing you to do this!!). You now hope that your average winning trade will be greater than your average losing trade and hence in a game of 50:50 you stand to achieve a profit. You have now refined your money management strategy based on your forward testing of this market. There's still not much science to your gaming, but based on an increased understanding of the parameters of the game you are evolving your methodologies.

It slowly starts to dawn on you that playing a game where the odds are 50:50 is limiting, the only way to increase the earning potential (other than increasing the average win size in respect of the average loss size) is to find a game where the odds can be engineered in your favour. Thoughts of poker enter your mind..Suddenly you realise the time - you've been at the table for over 4 hours! You quickly gather your chips (£110 in total) and head off to the wife.

What I have described above are the 3 basic elements of a successful money managment strategy.

• Avoid the risk of ruin
  
• Make average winners greater than average losers
  
• Increase the Win Loss ratio
  

Avoid the risk of ruin
I ensure every position I place is exposing a maximum of 4% of my account. Most professional traders would aim to reduce this to less than 1% - my target is 2% per position.
Never have more than 1 position in any correlated market (e.g. Dow and S&P, Gold and Silver, Long Dow and Short bonds).
After 3 consecutive losers, stop trading for the month.
When I hit my monthly target - (currently 7%) stop trading for the month

Make Average winners greater than average losers
My average winners are approx 1.5 to 2 times the size of my average losers. Keeping good records is the key to understanding how this statistic is changing. This is linked to the type of trading you are doing, but in essence the concept remains valid

Increase the Win Loss ratio
Clearly there is a relationship between Win/Loss ratios and average win/loss size however as a basic principle its important to always be looking at ways of increasing this ratio.