Money Management
Money management, or proper position sizing, is perhaps the most important element to a profitable trader. It’s all too common to see people holding on to losing positions, hoping that they will turn around and they will not have to realize a loss. These are usually the very same people that trade based on their emotions and tips, rather than the clear edges that define successful options traders. See the example below:
| System One
Percent Win: 85% Percent Loss: 15% Avg Profit: $500 Avg Loss: $1,500 Expectation per trade: $200 |
System Two
Percent Win: 45% Percent Loss: 55% Avg Profit: $1,500 Avg Loss: $500 Expectation per trade: $400 |
The examples above show how and why the desire to be right kills many traders. They focus on % winning trades and % losing trades instead of proper bet size (money management). System 2 is the better system. It makes more money. System 1 is all about ego (and long term losing). System 2 is all about the math – it’s simply a numbers game.
The first thing you have to do to keep your account properly managed is to limit your loss at any trade to 2% of your equity. Let’s say you have $10,000 in your trading account. So, you have to risk $10,000 x 2% = $200 in any of your trades. Set your stop loss to this level and you will not lose more than 2% of your equity. Some professional traders use somewhere around 0.5 – 1% position size rule. Depending in your risk tolerance, you move your 2% rule up to, say, 5%, but typically never any more than that.
Whenever you take a loss or make a profit you have to recalculate 2% of the equity to know your new maximum risk per trade. For example if you made a profit trade and your account now is $11,000, your maximum risk will be $220. At the other hand if you took a loss and your account now is $9,000, your maximum risk should be $180. In terms of take profit levels, you can apply the same principle to the upside if you are unsure where to take a profit – for example, if there is no technical level that you see in the very near future to take a profit at.
As long as you consistently exploit your edges, your winning trade percentage should be considerably higher than your losing trade percentage. If you practice consistent money management, you will effectively cut your losses short and your winning trade percentage of profitable trades will make you a net profitable trader in the long term.
