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MONEY MANAGEMENT
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Suppose you and I bet a penny on a coin flip: Tails, you win, heads, you lose. Suppose you have $10 of risk capital and I have $1. Even though I have less money, I have little to fear—it would take a string of 100 losses to wipe me out. We can play for a long time, unless two brokers get between us and drain our capital by commissions and slippage.

The odds will dramatically change if you and I raise our bet to a quarter. If I have only $1, then a string of only four losses will destroy me. If you have $10, you can afford to lose a quarter 40 times in a row. A series of four losses is likely to come much sooner than forty. All other factors being equal, the poorer of two traders is the first to go broke.

Most amateurs think that "other factors" are far from equal. They consider themselves brighter than the rest of us. The trading industry works hard to reinforce that delusion, telling traders that winners get the money lost by losers. They try to hide the fact that trading is a minus-sum game (see Section 3). Cocky amateurs take wild risks, producing commissions for brokers and profits for floor traders. When they blow themselves out of the market, new suckers come in because hope springs eternal.

Survival First

The first goal of money management is to ensure survival. You need to avoid risks that can put you out of business. The second goal is to earn a steady rate of return, and the third goal is to earn high returns — but survival comes first.

"Do not risk thy whole wad" is the first rule of trading. Losers violate it by betting too much on a single trade. They continue to trade the same or even a bigger size during a losing streak. Most losers go bust trying to trade their way out of a hole. Good money management can keep you out of the hole in the first place.

The deeper you fall, the more slippery your hole. If you lose 10 percent, you need to gain 11 percent to recoup that loss, but if you lose 20 percent, you need to gain 25 percent to come back. If you lose 40 percent, you need to make a whopping 67 percent, and if you lose 50 percent, you need to make 100 percent simply to recover. While losses grow arithmetically, the profits that are required to recoup them increase geometrically.

You have to know in advance how much you can lose — when and at what level you will cut your loss. Professionals tend to run as soon as they smell trouble and re-enter the market when they see fit. Amateurs hang on and hope.

Get Rich Slowly

An amateur trying to get rich quick is like a monkey out on a thin branch. He reaches for a ripe fruit but crashes when the branch breaks under his weight.

Institutional traders as a group tend to be more successful than private traders. They owe it to their bosses, who enforce discipline (See Section 14). If a trader loses more than his limit on a single trade, he is fired for insubordination. If he loses his monthly limit, his trading privileges are suspended for the rest of the month and he becomes a gofer, fetching other traders cof­fee. If he loses his monthly limit several times in a row, the company either fires or transfers him. This system makes institutional traders avoid losses. Private traders have to be their own enforcers.

An amateur who opens a $20,000 trading account and expects to run it into a million in two years is like a teenager who runs away to Hollywood to become a pop singer. He may succeed, but the exceptions only confirm the rule. Amateurs try to get rich quick but destroy themselves by taking wild risks. They may succeed for a while but hang themselves, given enough rope.

Amateurs often ask me what percentage profit they can make annually from trading. The answer depends on their skills or lack of such and market conditions. Amateurs never ask a more important question: "How much will I lose before I stop trading and re-evaluate myself, my system, and the markets?" If you focus on handling losses, profits will take care of themselves.

A person who makes 25 percent profit annually is a king of Wall Street. Many top-flight money managers would give away their firstborn child to be able to top this. A trader who can double his money in a year is a star—as rare as a pop musician or a top athlete.

If you set modest goals for yourself and achieve them, you can go very far. If you can make 30 percent annually, people will beg you to manage their money. If you manage $10 million —not an outlandish amount in today's markets —your management fee alone can run 6 percent of that, or $600,000 a year. If you make a 30 percent profit, you will keep 15 percent of it as an incentive fee — another $450,000. You will earn over a million dollars a year trading, without taking big risks. Keep these numbers in mind when you plan your next trade. Trade to establish the best track record, with steady gains and small drawdowns.

How Much to Risk

Most traders get killed by one of two bullets: ignorance or emotion. Amateurs act on hunches and stumble into trades that they should never take due to negative mathematical expectations. Those who survive the stage of virginal ignorance go on to design better systems. When they become more

confident, they lift their heads out of the foxholes —and the second bullet hits them! Confidence makes them greedy, they risk too much money on a trade, and a short string of losses blows them out of the market.

If you bet a quarter of your account on each trade, your ruin is guaranteed. You will be wiped out by a very short losing streak, which happens even with excellent trading systems. Even if you bet a tenth of your account on a trade, you will not survive much longer.

A professional cannot afford to lose more than a tiny percentage of his equity on a single trade. An amateur has the same attitude toward trading as an alcoholic has toward drinking. He sets out to have a good time, but winds up destroying himself.

Extensive testing has shown that the maximum amount a trader may lose on a single trade without damaging his long-term prospects is 2 percent of his equity. This limit includes slippage and commissions. If you have a $20,000 account, you may not risk more than $400 on any trade. If you have a $100,000 account, you may not risk more $2000 on a trade, but if you have only $10,000 in your account, then you can risk no more than $200 on a trade.

Most amateurs shake their heads when they hear this. Many have small accounts and the 2 percent rule throws a monkey wrench into the dreams of quick profits. Most successful professionals, on the other hand, consider the 2 percent limit too high. They do not allow themselves to risk more than 1 percent or 1.5 percent of their equity on any single trade.

The 2 percent rule puts a solid floor under the amount of damage the market can do to your account. Even a string of five or six losing trades will not cripple your prospects. In any case, if you are trading to create the best track record, you will not want to show more than a 6 percent or 8 percent monthly loss. When you hit that limit, stop trading for the rest of the month. Use this cooling-off period to reexamine yourself, your methods, and the markets.

The 2 percent rule keeps you out of riskier trades. When your system gives an entry signal, check to see where to place a logical stop. If that would expose more than 2 percent of your account equity — pass up that trade. It pays to wait for trades that allow very close stops (see Chapter 9). Waiting for them reduces the excitement of trading but enhances profit potential. You choose which of the two you really want.

The 2 percent rule helps you decide how many contracts to trade. For example, if you have $20,000 in your account, you may risk up to $400 per trade. If your system flags an attractive trade with a $275 risk, then you may trade only one contract. If the risk is only $175, then you can afford to trade two contracts.

What about pyramiding — increasing the size of your trading positions as a trade moves in your favor? The 2 percent rule helps here too. If you show profit on a trend-following position, you may add to it, as long as your existing position is at a break-even level or better and the risk on the addi­tional position does not exceed 2 percent of your equity.

Martingale Systems

Once you set your maximum risk per trade, you have to decide whether to risk the same amount on every trade. Most systems vary the amount of money at risk from trade to trade. One of the oldest money management systems is the martingale, originally developed for gambling. It has you bet a greater amount after a loss, in order to "come back." Needless to say, this approach has a great emotional appeal to losers.

A martingale player in a casino keeps betting $1 as long as he wins, but if he loses, he doubles up and bets $2. If he wins, he ends up with a $1 profit (-$1 + $2) and goes back to betting $1. If he loses, he doubles up again and bets $4. If he wins, he gets a $1 profit (-$1, -$2, +$4), but if he loses, he doubles up and bets $8. As long as he keeps doubling up, his very first win will cover all his losses and return a profit equal to his original bet.

A martingale system sounds like a no-lose proposition, until you realize that a long run of bad trades will wipe out every gambler, no matter how rich. At the extreme, a gambler who starts betting $1 and has 46 losses in a row, has to bet $70 trillion on his 47th bet—more than the net worth of the entire world (about $50 trillion). He is sure to run out of money or hit the house limit much sooner than that. A martingale system is futile if you have a negative or even-money expectation. It is self-defeating if you have a win­ning system and a positive expectation.

Amateurs love martingale systems because of their emotional appeal. There is a common superstition that you can get unlucky only up to a point and that bad luck is bound to change. Losers often trade more heavily after a drawdown. A loser fighting to come back often doubles his trading size after a loss. This is a very poor method of money management.

If you want to vary your trading size, logic requires you to trade more when your system is in gear with the market and making money. As your account grows, the 2 percent rule allows you to trade larger amounts. You should trade less when your system is out of sync with the market and losing money.

Optimal f

Some traders who develop computerized trading systems believe in trading what they call the optimal/—an "optimal fixed fraction" of the account. The fraction of capital they risk on any trade depends on a formula that is based on the performance of their trading system and their account size. It is a complex method, but whether you use it or not, you can borrow several sound ideas from it.

Ralph Vince has shown in his book, Portfolio Management Formulas, that: (1) optimal/keeps changing; (2) if you trade more than optimal/, you gain no benefit and are virtually certain to go broke; (3) if you trade less than optimal /, your risk decreases arithmetically but your profits decrease geometrically.

Trading at the optimal / is emotionally hard because it can lead to 85 per­cent drawdowns. It should be attempted only with true risk capital. The key point here is that if you trade more than the optimal fraction, you are certain to destroy your account. The lesson is: When in doubt, risk less.

Computerized testing of money management rules has confirmed several old-timers' rules and observations. The true measure of any system's financial risk is its biggest losing trade. A drawdown depends on the length of an adverse run, which can never be predicted. Diversification can buffer the drawdowns. You can diversify by trading different markets and using different systems. Closely related markets such as currencies offer no diversification. A small trader is forced to follow a simple rule: Put all your eggs into one basket and watch it like a hawk.

According to Vince, computer testing has proven several common money management rules: Never average down; never meet a margin call; if you must lighten up, liquidate your worst position; the first mistake is the cheapest.

Reinvesting Profits

Pay attention to what you feel when you handle profits. Many traders feel tom between a craving for a bigger and faster buck and a fear of losing. A professional trader calmly removes some money from his account, just as any other professional draws an income from his work. An amateur who fearfully grabs a profit and buys something with it before he can lose it shows little confidence in his ability to make money.

Reinvesting can turn a winning system into a losing one, but no method of

reinvesting profits can turn a losing system into a winning one. Leaving profits in your account allows you to make money faster by trading more contracts or being able to establish long-term positions using wider stops. Removing some of your profits provides a cash flow. The government also wants its share in taxes.

There is no hard and fast rule for splitting your profits between reinvestment and personal use. It depends on your personality and the size of your trading account. If you start with a small account, such as $50,000, you will not want to drain profits from it. When your account is well into six figures, you may begin treating it as an income-producing business.

You will need to make important personal decisions. Do you need $30,000 or $300,000 a year to live on? Are you willing to cut spending in order to leave more in your account? The answers to these questions depend on your personality. Make sure to use your intellect and not your emotions when you make these decisions.

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