Money Management Formulas

Why money management is vital? What happens if you don't put stop-loss?  Well, here is my view.

Have you ever asked yourself this question? Why do I trade for? Do I trade for the money or for the thrill? Please don't bother telling me, just show me your records.If you don't have your records then you KNOW the answer :-) , right ?

This is a very skillful lizard balancing nicely while looking through all around, almost 180 degree. Money management is an equivalent skill for you if you need to stay in market. Money management is like thus balancing act you got to do all through for every single trade. Without money management you are doomed to fail in this huge financial market.

Now you must guess HOW IMPORTANT it is to keep records for your trades. If you keep records, then slop of your equity curve will show how serious you are about trading.

This is how a profit/loss journal looks like. You can actually track your trades, see reasons behind your profits or losses and how well/bad you are doing and how you can improve by analyzing your past trades.

The goal of money management is to accumulating equity by reducing losses on loosing trades and maximizing gains on winning trades. Once you have your customized trading system, you must establish your money management rules and stick to them. So now you must be knowing that money management has got two goals: survival and prosperity. The first priority is to survive, then make steady gains and prosper.

In the above picture you can see the performance of first and second quarter of 2006. The graph shows steady growth of the account. four out of sixteen trades are loosing trades but they are well manageable and stopped with minor looses.

Following are the steps of money management.

• Measure your account value on the first of the month—the total of cash, cash equivalents, and open positions.
• Calculate 2% of your equity. This is the maximum you may risk on any given trade.
• Calculate 6% of your equity. This is the maximum you are permitted to lose in any given month, after which you must close out all trades and stop trading for the rest of that month.
• For every trade, decide on your entry point and a stop-loss; express your risk per share or per contract
• Divide 2% of your equity by your risk per share to find how many shares or contracts you may trade. To get a round number, round it down.
• Calculate your risk on all open positions by multiplying the distance from the entry point to the current stop by the number of shares or contracts. If the total risk is 4% of your account or less, you may add another position, since you’ll be adding 2% with your current trade, bringing the total to 6%. Remember, you do not have to risk 2% per trade; you may risk less if you like.
• Put on a trade ONLY after meeting all of the above conditions.

Remember, both your trading system and your money management must be good in order to win in the markets.

Once you are in a winning trade, trail your your stop to lock some portion(let's say about 60%) of your gain and risk rest 40% gain. This is called trailing stops.

If you keep on following your money management rules and maintain discipline you will definitely see huge improvement in your trading account.