MONEY MANAGEMENT RULES & GUIDELINES
Money management refers to a set of rules that aims to minimise your losses in the short-term and maximize your profits in the long-term.
■ Balancing your Decisions Between Reward, Time, and Risk
At any given time, the market offers a great number of risk/reward trade combinations.
- Asset A has the potential to move to Price X+5, but also the risk to go to the Price X-5, in N days
- Asset B has the potential to move to Price X+12, but also the risk to go to the Price X-10, in 2N days
- Asset C has the potential to move to Price X+32, but also the risk to go to the Price X-20, in 4N days
When you select a trade, you must consider all these variables:
Carefully balance every trading decision between these three variables. Don’t underestimate risk and don’t underestimate time.
■ Accepting Only High Probability Trades
If you bet your life’s savings, you can’t trade for fun. When you are exposed to market risk make sure you are sitting on high-probability bets. Accept only high-probability trades, even if this means that you will make a couple of trades every year.
A Bill Lipschutz says: “Don’t be in the market when there is no high probability trade. If most traders would learn how to sit on their hands 50% of the time, they would make a lot more money.”
Victor Sperandeo says: “Gambling involves taking a risk when the odds are against you... I think successful trading, or poker playing for that matter, involves speculating rather than gambling. Successful speculation implies taking risks when the odds are in your favor.“
■ Hold on to your Winners and cut your Losers
Professional traders make the majority of their annual profits by running 20% of their trades. However, in order to make money out of a few trades, you must run your profits.
If the market moves too fast you can withdraw your initial capital and trade only your profits. Victor Sperandeo says: “I analyze risk by measuring the extent and duration of price swings. For example, if the market has risen 20 percent in roughly 107 days, even if I'm still extremely bullish I'll have a maximum position size of 50 percent because statistically, we've reached the median historical magnitude and duration of an up move.”
If for any reason you become uncertain about your trades, you can:
- Enter a trailing-stop order instead of closing your position
- Withdraw your initial investment and stay with the profits
- Scale-out your position
As Michael Marcus says, if you don't stay with your winners, you are not going to be able to pay for the losers.
Being able to cut your losing trades is equally important. Joe Vidich says: “It is really important to manage your emotional attachment to losses and gains. You want to limit your size in any position so that fear does not become the prevailing instinct guiding your judgment.”
■ Make Small Bets in the Market -Whatever you Think your Position Ought to be, Cut it at Least in Half
Most professional traders bet less than 2% of their capital on an idea. Other pros don’t bet more than 1% of their trading capital on any trade. As Larry Hite says: “I have two basic rules about winning in trading as well as in life:
- If you don't bet, you can't win
- If you lose all your chips, you can't bet”
If you bet 50% of your capital on a single idea and lose, you need 100% on the next trade just to cover this single loss. Protecting your capital is the most important thing, and trading small positions is the best tactic to protect your capital.
As Bruce Kovner says: “My experience with novice traders is that they trade three to five times too big. They are taking 5 to 10 percent risks on a trade when they should be taking 1 to 2 percent risks. “
Position sizing is the easiest and most efficient way to manage your portfolio’s risk. Joe Vidich says: “The larger the position, the greater the danger that trading decisions will be driven by fear rather than by judgment and experience. If you are diversified enough, then no single trade is particularly painful. The critical risk controls are being diversified and cutting your exposure when you don’t understand what the markets are doing and why you are wrong.”
■ Never Overtrade and Protect Your Capital
The most important task when trading in the financial markets is to stay alive for another day. If you have the talent and at the same time you can protect your capital, it is a matter of time before you make serious money.
Paul Tudor Jones says: “Decrease your trading volume when you are trading poorly; increase your volume when you are trading well. Never trade in situations where you don't have control. My guiding philosophy is playing great defense. Always maintain your sense of confidence, but keep it in check.”
■ Losing Trade Doesn’t Mean a Bad Trade
As tomorrow is uncertain you have no control over the future market conditions. Even the most sophisticated trades can prove to be losers. For example, a natural disaster or a critical regulatory change can destroy any high-probability trade. Not even mentioning what a Black Swan event can do to the market.
As Larry Hite says: “There are really four kinds of trades or bets: Good bets, bad bets, winning bets, and losing bets. Most people think that a losing trade was a bad bet. That is absolutely wrong. You can lose money even on a good bet.”
■ When the Market Hurts you, it is Time to Get Out
One of the most critical requirements of successful trading is always staying objective and emotionally detached. If you can’t manage to stay emotionally detached then it is time to tighten your exposure, or even get out of the market.
As Randy McKay points out: “When I get hurt in the market, I get the hell out. It doesn't matter at all where the market is trading. I just get out, because I believe that once you're hurt in the market, your decisions are going to be far less objective than they are when you're doing well.”
■ Stop-Hunting Follows the Direction of the Greatest Price Vulnerability
That is a key piece of information for understanding and explaining the short-term market trends. When the great majority of speculators trade in the same direction, institutional players have a huge incentive to move the market in the opposite direction and force these speculators to be stopped-out. That unethical but very real practice of institutional players is called stop-hunting. In addition, as more and more speculators apply capital leverage, there are often short-squeeze or long-squeeze market conditions that further enhance price vulnerability.
A Bill Lipschutz says: “Stops are picked off by institutional players when the liquidity is shrinking and follow the direction of the greatest price vulnerability (up or down).”
■ Transaction Costs Matter a Lot
Most traders believe that if you sell higher than you buy, you make money. That is far from the truth. Trading consists of a great number of transaction costs that may be hidden until of course they are paid:
- Expensive spreads on limited-liquidity assets
- Wide spreads during after-hours trading
- Price slippage during news-releases
- Extreme overnight rates (SWAP rates)
- Capital leverage increases transaction cost
When applying high capital leverage, the transaction cost can ruin your entire portfolio in a very short period of time. William Eckhardt says: “The major factor that whittles down small customer accounts is not that the small traders are so inevitably wrong, but simply that they can't beat their own transaction costs. By transaction costs, I mean not only commissions but also the skid in placing an order. As a pit trader, I was on the other side of that skid.”
■ Enter/Exit the Market using DCA (Dollar Cost Averaging)
Dollar-cost averaging (DCA) refers to an investment strategy in which the total capital to be invested is divided across periodic purchases. That means instead of investing $12,000 directly on an asset, you buy a monthly of $1,000 of this asset, for a whole year.
That simple strategy aims to reduce the impact of volatility on the overall purchase. When investing in highly volatile assets such as Bitcoin, maybe DCA is the best way to do it.
Joe Vidich says: “I scale out, and I also scale in. The idea is don’t try to be 100 percent right. That way you will never be completely wrong, and you can reassess the situation if the market goes lower. It is all about keeping the portfolio from weighing you down.”
■ Use a Time Stop along with a Price Stop
Time is very important, especially if you have to pay high overnight rates to maintain your positions. In that sense, it is rational to have time stops along with price stops.
Paul Tudor Jones says: “When I trade, I don't just use a price stop, I also use a time stop. If I think a market should break, and it doesn't, I will often get out even if I am not losing any money. I am always thinking about losing money as opposed to making money. Don’t focus on making money; focus on protecting what you have. At the end of the day, the most important thing is how good are you at risk control.”
■ Reward/Risk Ratio - Successful Trading Requires Only a Few Big Winners
Most retail traders open trades with a Reward/Risk ratio of 1:1 to 2:1. However, if you trade using 1:1 Reward/Risk you need at least a 55% winning ratio just not to lose your own money (given the transaction cost). On the contrary, professional traders open trades with a 5:1 Reward/Risk, or even higher. If you trade with 5:1 R/R, you may lose 3 positions and still make a decent profit. This is a big deal.
Paul Tudor Jones says “I’m looking for a 5:1 Reward/Risk ratio. Five to one means I’m risking one dollar to make five. What five to one does is allow you to have a hit ratio of 20%. I can actually be a complete imbecile. I can be wrong 80% of the time, and I’m still not going to lose. I look for opportunities with tremendously skewed reward-risk opportunities. Don’t ever let them get into your pocket – that means there’s no reason to leverage substantially. There’s no reason to make substantial amounts of financial risk ever because you should always be able to find something where you can skew the reward risk relationship so greatly in your favor that you can take a variety of small investments with great reward-risk opportunities that should give you minimum drawdown pain and maximum upside opportunities.”
Peter Lynch says: “All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out.
- The typical big winner generally takes three to ten years or more to play out.
- You have to know when you’re wrong. Then you sell. Most stocks I buy are a mistake.
- Everyone has the brainpower to make money in stocks. Not everyone has the stomach.”
■ Good Trading Should be Boring, not Entertaining
That is useful advice for those betting on their lifetime savings without being too serious about it.
George Soros says: “If investing is entertaining if you’re having fun, you’re probably not making any money. Good investing is boring and personal emotions have no place in investing. If you want to be successful in the long run, base your investment decisions on rationality and discipline.”
■ To Fail is to Learn
If you apply proper risk management and position sizing, failing is just another step towards becoming a better trader. Even the most successful traders fail quite often. What is important is to learn from your mistakes.
Ray Dalio says: “How do you distinguish failure from learning? If it's part of a 'You're failing and then you learn,' then that learning is part of moving forward.
- The process is like, fail, learn, move forward
- Mistakes are the path to progress
- If you’re not failing, you’re not pushing your limits, and if you’re not pushing your limits, you’re not maximizing your potential
- The challenges you face will test and strengthen you.”
□ MONEY MANAGEMENT
(c) February 2021, for CurrenciesFx.com (c)
- TradingCenter.org (https://tradingcenter.org/)
- Visual Capitalist (https://www.visualcapitalist.com/all-of-the-worlds-money-and-markets-in-one-visualization-2020/)
- Hedge Fund Market Wizards: How Winning Traders Win (Jack D. Schwager)
- The New Market Wizards: Conversations with America's Top Traders (Jack D. Schwager)
- Market Wizards, Updated: Interviews with Top Traders (Jack D. Schwager)