Money Management as Your Trading Account Grows

This is taken from: http://www.hubb.com.au/tradingtutors/emails/2009/TradingTutorsEmail_020409.asp

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One of the reasons that traders tend to overtrade is that they are trying to make too much money, too quickly, with a trading account that is too small.

During the online training sessions I run for new Safety in the Market students, I ask students to think about the financial goals they are trying to achieve from their trading during the year.

For example, let’s assume you aim to make $100,000 per year from your trading.

You have a $5,000 trading account, you will risk 5% of the account per trade and will aim to achieve a minimum of a 2 to 1 Reward to Risk Ratio. This means that your losses should be no more than $250 per trade (including brokerage) and your profits should be at least $500 per trade (after brokerage).

I encourage students to focus on 10 trades at a time. It doesn’t matter whether you take those 10 trades in one day, one week, one month… Just take 10 consecutive trades, and focus on the results. I suggest that new traders aim to have 4 winning trades, 4 losing trades, and 2 “breakeven trades” out of every 10 trades they take.

What does this mean for our trading account? Well, the 4 winning trades should return at least $2,000 (4 x $500). The 4 losing trades should lose no more than $1,000 (4 x $250). The 2 breakeven trades cost us nothing.

If you can achieve this mediocre success rate of 4 winning trades out of 10 with a conservative 2 to 1 Reward to Risk Ratio, then every 10 trades would be worth $1,000 to you.

This gives you a 20% return on your trading capital. Not bad.

So to make $100,000 profit, you would need to take 1000 trades (100 x 10).

We set our target low because if we know that 4 winning trades out of 10 will help us reach our goals, we don’t mind if the first two trades, for example, are losing trades, because we can see the big picture.

Contrast this with aiming for 7 out of 10 winning trades – if your first two trades lose, you can start to panic, and take trades that you shouldn’t.

You then need to ask yourself whether it is safe and reasonable to make 1000 trades during a year – after all, this equates to around 4 trades per trading day.

The answer for most people is probably not.

So we need to adjust the parameters of our trading system.

Many traders will look to increase their risk size – and maybe start risking 6% or 8% or 10%, in order to get where they want to go faster. This is dangerous and can lead to serious depletion of your trading capital if you have a bad run.

Or, they will aim for a higher success rate. While this is a good idea, the reality is it can take a few years in the market before you have the experience to be making, say, 7 winning trades out of 10 consistently. If you aim too high too early, you can find yourself disappointed, and “chasing” extra trades as you play catch up.

I suggest students work out a compounding plan instead.

For example, maintaining the same parameters as above, we know that every 10 trades are worth $1,000. So after 50 trades, we would expect our trading account to double in value from $5,000 to $10,000.

We can now risk $500 per trade, which is still only 5% of our new trading balance of $10,000.

Now every 10 trades is worth $2,000, so 50 more trades would see us at $20,000.

By risking 5% of $20,000, or $1,000, each 10 trades should now be worth at least $4,000 to us, so 50 more trades would see us at $40,000.

Risking 5% of $40,000, or $2,000, each 10 trades should now be worth at least $8,000 to us, so 50 more trades would see us at $80,000.

30 more trades from here would see us make $24,000, giving a profit of at least $99,000.

So by increasing our position sizes as our account grows, you can see that we can still risk 5% per trade, still only require a mediocre 4 wins out of 10, and still make around $100,000 profit in 230 trades.

230 trades in a year is less than one trade per day – this is far safer and far more achievable than taking 1000 trades in a year.

Remember too that 5% loss is our maximum loss, and 2 to 1 is our minimum reward. And we may well do better than 4 winning trades out of 10. In this case, we would achieve our final target well before 230 trades.

The point is, we have a minimum standard to aim at, and we know that if we reach this standard, it is simply a matter of finding and executing 230 trades in a year.

Having this rock solid plan in place will help to keep you from over trading, and help keep you focused on your goals.

Trading is a business – treat it like one.

Be Prepared!

Mathew Barnes