No matter what type of trader you are or how much capital you have, I believe there is one thing that is more important to your long-term success than anything else. This “Holy Grail” of trading is money management. It takes discipline, but good money management can mean the difference between success and failure.
If you are not using proper money management techniques, you might as well go to Las Vegas, spin the wheel, and hope the ball falls on your preferred color. Over the course of my career, I’ve never been that kind of a trader, and don’t recommend that approach for my clients either.
Whether you are a fundamental or technical trader, whether you are a day-trader or position trader, and whether your bankroll is big or small, you need proper money management. These are rules to guide your trading, and they take the emotion out of the marketplace.
I’m going to offer a few tips I’ve learned over the years. I encourage you to seek out more information on this subject so you can establish the right money management techniques to suit your unique situation. There are different methods you can incorporate into your own unique trading plan, but I believe there are some core concepts all traders should follow. First, let’s look at capital.
How Much Money Should I Risk Per Trade?
Before you even get into a trade, you should determine how much money you can afford to lose on each trade. And, you should outline a hoped-for profit objective on each trade too. Remember, futures trading should never be entered into without a lot of thought. The money you allocate for futures trading should be money you can afford to lose (risk capital), not money to meet your day-to-day living expenses. You don’t want to overextend yourself and wind up losing all your risk capital on one trade. Don’t put $10,000 on the line if you have a $10,000 to invest, no matter how strong your convictions. No one is 100 percent right all the time, not even the world’s greatest traders. Do you want to bet the farm, and risk losing it, or do you want long-term investment success?
If you have a $20,000 account (risk capital), does that mean you should then bet $10,000 or more on one trade? Absolutely not. One rule of good money management is to never have more than 5 – 10 percent of your total risk capital on the line in any one trade. I’m not taking about the margin (performance bond) you need to put up to enter your trade or maintain your position, I’m talking about what you are willing to risk losing on a particular trade if it goes against you and you have to bail out.
Your trading time frame and frequency can help determine the appropriate amount to risk within that 5 – 10 percent range. If you are a day trader, I would recommend you risk less (closer to 5 percent), because you are going to be trading more and want to leave yourself more ammunition. If you are a swing trader and you trade less often, you can risk a little more. If you are a position trader with a longer-term trading focus and less trading frequency, you can risk the most, perhaps 10 percent.
So, let’s use my 5 – 10 percent rule of thumb and look at how that would work in practice. I am going to simply define my risk and reward based on contract values for the purposes of this discussion. Let’s assume I have a $25,000 account and I want to risk 5 percent, or $1,250, on one trade. If you are looking at trading CME E-mini S&P 500 futures, you will see in the contract specifications that each one-point move is worth $50. That means if I wanted to risk $1,250, the market can move 25 points against me before I’m out. If I buy a contract, then, I’d place my stop-loss 25-points lower. If I sell a contract, I’d place my stop-loss 25-points higher.
Using Technical Analysis
You can decide what percentage you want to risk of your account, and you can pick specific levels using technical analysis that determine when you will enter and exit a trade. Traders have their own unique rules based on this concept. You can decide what your rules should be. I like to use pivot points as support and resistance when formulating strategies for my clients, because they give me a clear number to define where to enter and exit trades. Chart patterns also can define appropriate risk and reward parameters. You might look for the market to break out of a triangle pattern, for example. You can use technical analysis techniques to help you find support points within your 5-10 percent risk parameters.
As mentioned, using support and resistance is a good way to define your risk. Let’s use gold as an example of how this works in practice. Look at the price action in the chart below from December 2009 – April 2010. I am looking for a trend line, and then support areas, to help define my risk. I would want to buy near the support area, and place a stop somewhere below that level. So I may buy at $1,110 and put a stop at $1,080 on the downside. I’ll determine whether these levels are suitable in terms of money risk, based on my account size.
Calculating Risk and Reward Ratios
Now that you have defined your loss threshold, you also need a profit target. Little wins, and big losses come from failing to obey good money management principles. Always have a profit target that’s much greater than what you are willing to risk. It might not ultimately work out that way in practice, but that’s your goal.
For day traders, 1.5 percent is a good basis in terms of risk-reward ratio. That means if I risk $1,000, my goal on the trade is to make $1,500. Swing traders might go a little higher, at 1×2 (risk $1,000 to make $2,000). Position traders might consider risking even more, at 1×3 (risk $1,000 to make $3,000). That doesn’t mean I’ll get those exact dollar amounts in practice, but I’ve defined my goals and my limits before I even place the trade.
Why should position traders be willing to risk more? Because there is more volatility over the longer-term that can affect your risk, and you need more wiggle room to maintain your position though a longer time frame. Day traders need to retain more capital, because they are in and out of the market more often.
Trading Frequency
The biggest mistake I often see with new traders is that they are looking for the “career trade;” the big home run. It’s a great fantasy, but it’s not a realistic strategy. The successful traders over time aren’t necessarily scoring big winners—they are successful because they are managing their losses.
How many trades do I need to make to be successful? This may sound strange, but you can actually have more losing trades than winning trades and still be profitable, if you have the discipline to use proper money management. If I make four trades and net $2,000 on each, I’ve made $8,000. If I make six trades and I lose $1,000 on each, I’m down $6,000. Overall I’m still up $2,000, even though I had more losers than winners. So you see, it’s possible to be wrong more often than right and still be successful, if you set your risk-reward parameters correctly, and are disciplined enough to get out of losing trades before they become career-ending ones.
Use of Options
Setting stops based on chart patterns is one method of helping you define your risk, but you can also use options as an effective money management tool.
Let’s look at an example to help us decide if options might be a useful tool. Say I am a day trader, have a $10,000 account, want to buy a CME E-mini S&P 500 futures contract. I have determined that I will risk $500 on the trade, or 5 percent of my account value. How many points should I target for the market to move before I get out of the trade? As each one-point move in the E-mini S&P is worth $50, I will risk 10 points ($500/$50 = 10). If I’m a swing trader, I can risk a little more. I may use 10 percent, or risk $1,000. So a 20-point decline is what I’ll use for my stop-loss.
The S&P 500 chart below helps illustrate where we might place our buy and sell stops based on support and resistance.
Instead of using a stop, you could buy a put option to help define your risk. If the S&P is trading at 1175, you could buy a 1160 put for a move of 15 points. You would buy a put if you are long the underlying futures, or buy a call if you are short the underlying futures. If the futures market fell to 1160 and you had instead used a straight stop 15 points below your entry, you’d be out of the trade However, if you had used the option instead, the put would start to climb in value.
If the market then turned around and climbed to 1200 instead, your put would be worthless, and you’d be out only the amount of money you paid for it—and no more. But who cares? Your long futures position is now profitable, and the option did its job as a hedge against downside risk. Use of an option as a risk management tool is more suitable if you are looking for a greater move in the market over a longer time horizon, and may not want to be as precise in your forecast.
Exiting a Trade: Have a Reason
As mentioned, technical analysis is one way to determine where I might enter a trade and what I’d like to define as my risk. I buy based on my defined support points, sell based on my defined resistance points, and place my stop-loss points below or above those respective levels. Let’s explore the concept of exiting a trade a bit further, beyond just using support and resistance as tools to pinpoint specific levels. If your trade doesn’t look like it will make its profit target, do you just wait it out and hope it does? Or do you sweat it out, hoping it doesn’t become a loss?
I have a golden rule in terms of making the decision to get out of a trade, and it doesn’t matter if you are trading based on a technical chart pattern, or are watching fundamentals. As soon as your reasons for entering the trade are no longer valid, or have changed, then you’ve got to get out. You must have a reason for taking a trade, and also a reason for exiting the trade.
For example, if you bought a futures contract because of a bullish chart pattern, and then that pattern changes, you should get out of your trade. If a market breaks a certain trendline or key technical level you’ve identified, get out, even if the trade is still profitable. It might not be for long!
This concept also applies to fundamentals. If I’ve bought Treasury bond futures and on the belief the Federal Reserve would do or say xyz at their monetary policy meeting, and they don’t do or say xyz, then I get out. If I sold a Treasury bond contract because there is too much supply, and the results of a Treasury auction show a huge increase in demand, then I’m out. The point is, if my rationale for making a trade changes, I’m out, and on to the next trade. That’s discipline; sticking to your rules. If you can’t exercise discipline over the long haul, you’ll be out of the game.
Applying the Concepts
I’m going to take a look at a chart of the June CME S&P 500 futures during February and March 2010, and apply some of these concepts. Keep in mind the CME E-mini S&P 500 futures contract is worth $50 for each one-point move. Assume I’m a position trader and have a $25,000 account. Let’s look at another S&P chart.
In about four weeks, the market moved from about 1,135 up to 1,175. Say you are bullish but missed that move. Should you get long now, and where? Using technical analysis as a tool, I might look at the 38 percent retracement of that move, which comes in around 1161. To help define my risk, I’ll target a move below that retracement level as my exit point, perhaps in the area of 1153. That’s where I’d put my stop. So if I’m long an S&P futures contract from 1160, I’ll risk eight points to 1152, and ask myself if that level falls within the bracket of the chart pattern as well as my defined money risk parameters. For a move of eight points in the E-mini S&P, I’m risking $400 per contract. If I have a $25,000 account, that’s within my comfortable 5–10 percent range to risk on one trade.
Now, where do I set my profit target? I’ll look at the charts and might target a move up to 1180, near a resistance level I see. If I got long at 1160, my risk/reward parameter is 1×2.5, within my comfort zone for a position trader. If I’m a day trader, I might want to readjust my targets so I’m not taking on as much risk. For this example, I’m risking eight points on the downside, to make 20 on the upside. If perfect conditions exist, that 20-point move would earn me $1,000, and I’m risking $400 if I’m wrong. Of course in the real world, we have factors like slippage, commissions, unexpected market shocks, etc. that will affect both your potential profit, and loss. And either could be substantially larger or smaller than you have predetermined under your ideal scenario.
Jeffrey Friedman is a Senior Market Strategist with Lind Plus, Lind-Waldock’s broker-assisted division. For more information on this topic or others, he can be reached via phone at 866-231-7811 or email at jfriedman@lind-waldock.com.
Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.
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