Money Management and Risk of Ruin

Q. Money Management. Is it that important?


A: Yes, it is critical and it is a fact that good trading is mostly all down to your psychology (besides that of course you need to have an edge in the form of a trading plan!).

If going for a very short-term spread bet for instance you do not really know whether the price on a stock will go up or down. Prices change instantly and it is how you deal with these changes that will separate you from amateur traders.

Remember that you will always have losing bets but the aim is to win a bit more than you lose. In 17 trades If I bet 10 trades at £5/point and lose 10 points (stop loss set at 10) per trade that is a £500 loss but only win 7 trades at 20 points that is £700 profit. £700-£500 leaves you with £200 profit, you still end up ahead even though you lose more times. Consider the £500 loss as the cost of being in the business like any overhead. Never expect to win all your trades.

So as you can see you can have more losing trades than winning trades and still make money. The key here is to close out losing trades quickly with minimal losses. The idea is to keep your losing in focus with your winning trades and treat them as the same. With losing trades being a routine part of your spread bets you absolutely need to get yourself mentally setup to accept that losses are part of trading or you will end up quickly wiped out. So don't panic or get disillusioned when you lose, just analyse why that stock didn't perform and move on to the next trade.

Now the biggest challenge to this method is yourself. Can you absolutely stick to your trading plan without any emotion? If you can you will be a successful trader. If not, you will FAIL, period! You can be an expert in analysing charts, but if you let the emotions of fear, greed and negative thinking play on you then you will find it hard to be successful in spread betting.

The longer you trade the more you come to understand that psychology has a crucial part to play in your trading success. Fear becomes an intimate companion when our hard earned cash is gobbled up in a falling market and in such situations we react in quite unexpected ways which are not always pleasant. Greed and fear are the base emotions that trigger psychological reactions.

For instance what usually happens to amateurs is that they get to -10 points and they always wait to see if it will get back to 0 so they can walk away without losing any money then OUCH, it's now at -20, -30, they then get out feeling cheated and angry at the market. Recognizing repeated self-defeating behaviours like failing to act on a stop loss, is the first step towards overcoming and changing, these responses.

Remember if you lose £500 in a day you have to make £1000 the next day to be back in profit by £500, scary!

P.S. When trading you never want to wiped out with one trade that is poorly managed which implies that you should never place a trade where you use all your capital.

I hear a lot of investors blowing their accounts. That is not good. You need money management or else you will never make it. Let me put it this way...if you have $1000 to trade with and that's all you have are you going risk it all in one trade? That is what I call a big gamble. Every time you trade you should ask yourself...if I lose this trade will I lose all my money? If the answer is yes, then you need to make smaller trades. Sure you might hit that $1000 trade and perhaps double your account but what's going to happen is that you will give it all back because you have that inner demon that keeps pushing you...I can keep hitting these risky trades...I will keep winning. But that's not true. It's better to win little by little without risking much because remember this is not a sprint, this is a marathon.

Q. But why are discipline and money management important?

A: Successful trading really is as much about controlling your losses as hitting more winners than losers. Problem is that as humans we are wired to run losses and realise profits...

i.e. When people are losing money most people will let it run and not cut their losses...similarly people are much happier to realise profits as it's obviously a 'nice' thing to do.

Good trading/investment is all about discipline 'the first cut is the cheapest' is an expression often heard in the markets.

The reason most investment funds underperform the index is because of this. Unless you think you are ruthless enough to cut your losses and to do it early when you make a mistake don't start trading to try and earn a living. It's VERY hard work and VERY stressful.

Let's now look at the technical side of things with a trading example. This is contributed by Henry - a professional trader -:

The below chart was taken from FTSE first thing this morning so completely at random. One of the three and probably the most profitable strategy is to trade the price bars without indicators. The other two strategies involve CCI/RSI and TEMA (Triple Exponential Moving Average). Nothing to be secretive about imo. They all work but are all loss making without discipline and money management. That's why winning traders don't mind giving their systems away - they know the majority of traders can't accept the discipline of taking a run of losing trades without having to chicken out and try something different. If you get 70% wins you must be able to cope with 30% losses. That may involve say the occasional five or six losing trades in a row and for a lot of people that is hard to do so they start to get desperate and try to 'improve' the strategy. Truth is that they have given up. Chances are they stop trading just as the winning trades start again so frustration kicks in and emotions get damaged beyond repair. I've been there.

International Personal Finance

For me it's important that a trader can read a chart and trade from it without indicators before they use indicators. I made that mistake for years and only in the past year saw the light. Simply look at the bars. They tend to trend up or they turn and trend down. The only alternative is that they consolidate and move sideways or break into reverse trend or continuation of the original trend. Nothing else is possible. Just look hard and see the turning points. Each one is a break of the closing price of the previous five bars. Nothing magic about it, you could just as easily pick on seven bars or any other number. I just see five bars works for me on the one minute chart because a lot of traders trade the five minute chart. Each time the price breaks the trend reverses. If you trade stocks long only just look for the trend reversal breaks and trade it with a stop at the previous h/l. You don't need indicators support or resistance. Just look for sound fundamentals and trade trend reversals after pullbacks. I would urge every new trader to learn this before bothering with indicators. Why do I also use indicators? I do it so as to diversify my positions. If I get a run of being stopped out on price action I have two other positions running that tend to oppose each other. At least one of my strategies will usually be winning more than the other two are losing. Often two strategies will be winning but seldom all three winning or losing at the same time. Indicators also give me some comfort when I have doubts about the price action reversal/continuation/consolidation signals.

This strategy works as the FTSE trades within various ranges from tight consolidations of 10 points to an average of 20 points and up to a maximum of 30 points. The waves occur within those ranges. I consider myself to be a trend following trader who tries to catch the bigger breakouts. The art for me is to just follow what has happened and accept the give back of a few points on every reversal. Others might be more comfortable with setting a target at the previous trading range but then you will close out a trade just as it breaks and lifts off. You can't have it both ways unless you diversify your strategy with alternatives. You then need a very sharp eye to be able to handle the trading. Alternatively you can trade say five minute and ten minute charts at the same time using pure price action without any indicators. There are thousands of strategies. They are not the issue. The issue is being able to execute the strategies and learn how to identify when not to trade. Never ever trade the mid range. Sit there for two or three hours doing nothing until you get a signal - then instantly hit the buttom. Accept that losing is OK, even several consecutive trades - no problem, at worse a mild 'shite'. The last four are far harder than most people appreciate.

20 points made on this strategy today in the first hour. 42 points made in three hours yesterday morning. £20 per point= £1240 = simple but not easy. Importantly it works on any chart timeframe with low spreads and reasonable liquidity.

So the strategy is unimportant; there are thousands on the internet from a simple MACD with a moving average to overbought/oversold, price action, fibs or trend following. Thousands of them and they all work. What doesn't work is the ability of the trader to manage the trade over weeks, months and years. Trading isn't about a strategy, it's about all the other things like money management, handling long losing periods without giving up, knowing all of your trading options before an opportunity or event arises.

For instance, do you know for your strategy what is the probability of say 5,10 or 15 consecutive losing trades? Do you know what % of your trading capital should be risked when VIX is say at 40 or 20? These are the sort of things that make a difference between the 20% winning traders and the 80% losing. The chart above was just to explain that technical indicators are relatively unimportant to be successful at trading. If you go to the US site Elite Traders you will find most higher regarded traders there don't use indicators at all and have scant regard for those who do. Their motto is Trade The Bars Not The Stars. I was fortunate to have one of them explain it all to me. Drop the indicators and just look at the bars.

Q. I want to know how do you define discipline? What is it that I must do to get it?

A: Discipline is sticking to your plan and strategy. In order to be able to define discipline, you must have a thoroughly defined strategy which allows for consistent application. Then, discipline means doing what you planned while steering clear of doing what you didn't plan for. The better, the more precisely defined trading strategy you have, i.e. the better you know what you should do, the easier it is to maintain discipline and sticking to your trading plan.

If you are not really sure what you are looking for in order to enter or exit a trade, then it is impossible to evaluate discipline. Some aspiring traders seek problems in discipline or emotions whereas their problem lies in the fact that they don't know exactly what it is that they are looking for, i.e. in their strategy and/or tactics. They seek problems in discipline when discipline can't even be defined in their case.

Another factor is confidence in what you are doing. Some people might take some mechanical strategy found on the internet, a strategy which is objectively defined, but they fail to stick with the system. Then, the problem is not that these people don't know what they should be looking for, but rather that they don't know why they should look for it. They don't understand the strategy and without understanding the methodology behind the strategy they have no trust in the system.

It is much easier to maintain discipline if you know why you are trading a specific trading method (and why you don't do what you don't). Additionally, it is much easier to trust something which you have developed and fine-tuned yourself, because then you know exactly all the why's. And of course, for confidence it is better if you base your strategy on some sound logic than on pure statistics and/or back-test optimization. Because the logic is the part you understand and trust, not the statistics. The statistics serve to test and confirm the logic. They are a tool to build your trust in the logic. But they can't become the confidence-founding logic themselves.

So my advice on how to 'get' discipline is to develop a precisely defined strategy which allows for consistent, reproducible application in order to be able to even define the discipline.

I think that discipline is required irrespective of how ones wishes to define it. Much like trading as a business - it requires hard work, research and a plan - the discipline to stick to those things.

I recall some wise trader saying something like: 'If you don't believe discipline, your self-knowledge and your psychology are important then you are not betting big enough.' There is a size where almost everyone starts to need more than "just" an edge and money management. It combines dollars, your immediate need, and your conditioning. I'm not saying you don't need an edge but you'd be surprised how weak an edge some of the big pros consider acceptable. I generally seek a profit factor of 2 to 3 (sum of wins over sum of losses) but when you read the truthful writings of some of the current big players you discover that a 1.5 profit factor is all they're looking for in their edge.

Q. How do you get/improve discipline in trading?

A: Discipline involves planning, developing a process (that involves thought, and testing), and applying the plan. On a regular recurring basis. (Practice, practice, practice the more you do the easier discipline becomes (be it good or bad habits)).

General tips to get/improve discipline (of course these come with the caveat that you have to have some sort of discipline to do these):

  1. Develop a trading plan, this should include strategy/edge/beliefs etc;
  2. Plan your trades - know why you are doing them, what your entries, exits are etc;
  3. Follow your plan. (tweak it, improve it, but stick to it if it works)

If you cannot follow these steps 1-3 (in some form or another) then I suggest try another occupation other than trading. They are not hard, and the format and the detail is up to you. But if you cannot really be bothered to even first think about and try and follow some sort of plan/methodology/style/system/idea then I feel that a successful long term trading career will evade you. As you do 1-3, and the more you do 1-3 then the easier trading seems, the more relaxing it seems, and the less of a chore it seems. (That's probably where intuition kicks in as its second nature and experience, easy as ABC - 123).

Q. Why is it so important to preserve your capital?

A: A suitably-funded account and capital preservation are, in my view, the primary fundamentals of stock market trading. Most traders get excited about the potential to make lots of monies trading stocks but they often forget that it is even more important not to lose money. In fact there is one critical factor to consider when trading - each time you lose money, it is harder to recover it back. And the more you loss the more uphill the road becomes. Why?

Let's start with a trading pot of £10,000 -:

Lose 10% to £9000 - Now you need to make £1000 on £9000 or 11% to get back to breakeven.

Lose 15% to £8500 - Now you need to make £1500 on £8500 or 17% to get back to breakeven.

Lose 20% to £8000 - Now you need to make £2000 on £8000 or 25% to get back to breakeven.

Lose 25% to £7500 - Now you need to make £2500 on £7500 or 33% to get back to breakeven.

Lose 33% to £6700 - Now you need to make £3300 on £6700 or 50% to get back to breakeven.

Lose 50% to £5000 - Now you need to make £5000 on £5000 or 100% to get back to breakeven.

Remember that when spread betting and with trading in general you will experience ups and downs and there will always be some months when you lose money (anyone telling you otherwise is simply lying). This means that you must control your risk at all times because it takes a bigger profit to offset a corresponding loss. This is also why I recommend you to start with a trading pot of at least £10,000 as this will allow you to spread your risk. Also, if you lose a third of your capital you should seriously consider stopping and taking a break from trading.

Traders often try to carry too big a position with very little capital, and/or trade too frequently for the size of the account.

Q. How do you calculate your risk of ruin?

A: Kaufman gives us the following formula for calculating the risk of ruin:

risk_of_ruin = ((1 - Edge)/(1 + Edge)) ^ Capital_Units

where Edge is the probability of a win.

This formula calculates the risk of blowing out your trading account and is probably derived from this simple formula:

Suppose you throw a coin, heads you win and tails you lose. The probability of losing is 1 of 2 outcomes or 1/2 (i.e. 50%). If you have $10,000 in capital and you bet it all on one throw then the risk of ruin is 50% since if you lose on the throw you lose all your outlay and you're out the game.

Now, let's suppose you decide to risk only 1/2 of your money. In this instance, the probability of losing on the first throw of the coin is 50% and the probability of losing on the second throw is 50%. And the possibility that you will lose in both throws 50% x 50% or 25%. This reduces the probability of ruin to 25% but again two negative outcomes in a row consumes your entire capital.

As you can see if you only risk 2% of your capital or $200, you would have to lose on 50 consecutive throws ($10,000/$200) to blow your account - this in practical terms is very much unlikely.

When calculating the 'Risk of Ruin' you will notice that the bigger the edge value, the lower will be the risk or ruin (which is logical as the bigger the edge the more likely you will have winning trades). Also, the greater the number of capital units employed the lower the risk of ruin. Again, this should be obvious: the smaller the amount you risk for any one trade relative to your capital base the lower the risk of ruin.

The risk of ruin is greatest when you're just starting out - this is because your capital base is smallest at this point and if you are unfortunate and immediately hit a string of losses it will take a smaller succession of losses to wipe out your account. Another reason why risk of ruin might be greatest in the beginning is due to lack of experience - an experienced trader who has survived for a long time will have overcome losing habits that a new trader may still have.

Q. Ok, I've read a lot about money management but I don't have a 10k plus a/c. The concept of risking not more than 2% is impossible...

if you only have a few grand. Even if your account has 25k, 2% is only $500. Tell me how you will make any money buying only $500 in stock on each trade? You can't possibly buy sufficient shares to make it worthwhile...?

A: The 2% (or whatever you decide your risk level to be) is the loss amount you can take, not your position size. So in your case you can increase your leverage while retaining your 2% risk level...

Let's say a stock is $10 a share, and you have your stop set at $9.50. If you are stopped out at $9.50, your loss would amount to $0.50 a share. You then calculate out a position size so that if you are stopped out, the total loss you would suffer would still amount to 2% of your total account size.

If you were trading a $10K account in this scenario, and wanted to use a 2% risk level, your maximum loss is $200. With a possible $0.50 per share loss, this means your position size could be 400 shares (400 shares, stopped out at a $0.50 loss is a $200 total loss).

If your stop was placed at $9 per share, that would be a $1 per share loss if you were stopped out, so you could only take a position of 200 shares (200 shares at $1 possible loss per share - $200 max loss).

This part confused me at first as well. Hope this clears it up.

 ...Continues here - Getting Rich Fast from Trading?

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