Money Management

I have mentored numerous beginning and intermediate traders. I have also co-founded a Trading Club which meets six times a year and has nearly 200 members. I talk to other traders regularly and I often answer trader’s questions. The ONE key area that leads to the greatest losses among beginning and intermediate traders in poor Money Management.

Critical Principle:    If you do not master Money Management you cannot master Trading

So what is Money Management?

It is simply managing your money and managing your risk.

The reason it is so difficult to master is that the elation of making money and the pain of losing money are among the most powerful human emotions. When we become gripped with these emotions, or even the imagination of what those states would feel like, most people stop thinking rationally and start acting in a high adrenaline mode. This high adrenaline mode is great if you are in physical danger or you are exerting yourself in an exciting adventure. But it is NOT conducive to good trading.

The Four Contributors to Poor Money Management

1. Risk

Please see the separate page www.TradingBook.org/risk

2. Discipline

A lack of discipline is also a cause of a lot of losses in new and intermediate traders.

Such undisciplined habits include:

Not triple checking a trade (levels, position size and risk) just before you execute it;
Not writing down the reasons you took the trade;
Not spreadsheeting the trade so you have a record of it;
Not doing a daily revaluation of all positions so you know your profit and loss on an ongoing basis;
Not going back and regularly analyzing where you made money and how, and where you lost money and how.
And so on.

A close cousin to a lack of Discipline is the next point…

3. Laziness

It must also be said that poor money management is in many cases rooted in Laziness. Traders often cannot be bothered to calculate the exact percentage risk and the exact dollar risk of each position. More dangerously many traders do not calculate the risk of combined and correlated positions. So for example if you have the following positions:

  • Long AUD USD
  • Long NZD USD
  • Long EUR USD
  • Long GBP USD
  • Short USD JPY
what you actually have is one BIG position that is short USD. If the USD strengthens you could be stopped out of all of your positions in one session. This might be a five times bigger loss than you were expecting.

Let me tell you about Laziness and lack of Discipline. It takes just a few minutes to:
  • Triple checking every trade (levels, position size and risk) just before you execute it;
  • Write down the reasons you took the trade;
  • Spreadsheet every trade so you have a record of it;
  • Do a daily revaluation of all positions so you know your profit and loss on an ongoing basis;
  • Go back and regularly analyze where you made money and how, and where you lost money and how.
The losses that are racked up by people not doing the above means that the exact same people who are lazy actually have to go to work for days and weeks and sometimes months to get back the money they lost!

The few minutes they saved has become hundreds of hours they have to put in just to get back to even!

If this is you, do yourself a favor. Do the easy and quick work – be disciplined in your trading!

4. Lack of Understanding

New and intermediate traders often simply do not understand what they are trading and how the financial instrument works.

One of the best examples is writing or selling options.

When you are a seller of an option YOU take all the risk. In fact the profit potential is limited and the loss potential is unlimited.

The attraction in selling options is that someone pays you a premium. So as soon as you sell the option someone pays you money. As an example say you sell a currency option for three months and you are paid $1,000. It is completely conceivable that in three months time you could owe the person you sold the option to $25,000!!!

Let me give you a real life example. In the bull run in equities in 2005-2007 a lot of new traders were advised to sell put options on stocks. If stocks (shares) kept going up the trader just kept the premium. So I heard of a school teacher who started doing this. Month after month stocks kept going up and he made $1,000 a month, $2,000 a month, $4,000 a month! Fantastic. But what this trader didn’t know was the risk he was carrying. In the meltdown of 2008 this humble school teacher had to PAY OUT on the options he was selling and lost over $100,000 and lost his house.

Incidentally I NEVER sell options. I do buy options but that is fine because my risk is limited to the premium I am paying and I have unlimited potential to make money.

For more information on Discipline see:


For more information on using Stop Losses to reduce risk see:

 
 
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