Tuesday, April 12, 2005

Money Management - an overview

Every wise crack is telling you about Trade mangement and Money management, how important they are and that without them, you will have no chance to survive in this business.

Total BS I thought, when I found myself again in a trade being down 10 ticks and facing again either a loss of 125$ + comm or continue waiting for a move back-up to Breakeven + 1 tick. Can’t tell how many hours I was in such trades.

Still a presentation given by Sport a year or so ago in Woodies room got me thinking about the subject again.

Sure your options being a 1 contract trader are limited. None the less Money management rules apply to you as well.

Money Management means deciding based on your current account balance

  • What instrument you trade
  • What risk you can/should take based on your account size and
  • How many contracts you trade

You need to know the risk inherent in every instrument you want to trade. Let’s compare the US 30y Bonds (ZB) and the S&P500 (ES).

The ES pays per tick 12.50$ vs 31.25$ with the Bonds. So if you want to trade the Bonds, even if they are highly trending contracts you need to decide, if you can afford the Stopamount the Bonds will cost you in case you are wrong. Let’s say you need on average 5–6 ticks to decide you are wrong in the Bonds, that your signal is not valid. This will cost you about 160$ to 192$/ trade. On the other hand on ES the same 5–6 ticks will cost you 65$ – 78$.

Based on your account size, you might have to decide, that even if the ZB looks nice, that even if you get the signals fairly correct, you can’t trade it due to the risk inherent in the high tick value.

How many contracts you can trade is first determined by the margin necessary to trade 1 contract. With a 10k account you could trade

  • 5 contracts ES intraday
  • 10 contracts ZB intraday

So the exchanges view the risk trading the ES a lot higher than the risk trading ZB. To determine margin the exchanges look at the average daily range the instruments do and apply a special formula to arrive at the necessary margin to trade 1 contract.

But I can guarantee you, that most of you reading this blog will be out of business within a month, if you decide to trade upto 10 contracts ZB in a 10k account.

So, how do you determine how many contracts you can trade with a 10k account?

Old traders will tell you, you need 5k to 8k trading 1 contract to be able to weather most storms the market will throw at you. I myself traded 1 contrat with a 2k-3k account for 2 years. But since I crossed the 5k barrier I feel better. Now I trade 1 contract with a 10k account and Scale-In a trade for eventual 2 contract trades, if I get them. 

An objective formula is to risk no more than 1–2% of your account size with any one trade.
So, if your average Stop is 150$, the account size recommended to trade 1 contract should be anywhere between 7.5k to 15k.
Btw: The reason, why I remaind for 2 years in the 2–3k range was simple: I was an undercapitalized novice daytrader, who had had huge swing trading losses. I could not afford a single loss and that means you get a lot of these. It’s just the way it is. But for me it meant healing from prior huge losses, it meant learning, what it meant to be a daytrader, it meant learning the necessary skills to survive.

I’m still usually trading 1 contract, because my Money Management spreadsheet tells me, that using this strategy I will have consistent profits.

to be continued…