Trading money management: the part that actually pays

Good money management is what lets you obey the two cardinal rules of trading: let your profits run and cut your losses short. With the rules predefined, your system runs on autopilot. You never stand there mid-trade asking, should I hold on to this stock or shouldn't I?

That indecision is exactly what confronts traders who have no rules in place, and it's why most traders fail when they come to the market: they end up relying on their emotions to make trading decisions, and emotional traders hold on to losing stocks.

All big losses start small

Keep in mind that every big loss once began as a small loss. Let a losing trade run and it eats into your trading capital, and once you take a couple of big losses it becomes much harder to trade your way back to where you started. Worse, if you wipe out your trading float entirely, as many traders do when they first get started, you cannot continue to trade at all. The maths of digging out of a drawdown is covered in how much trading capital to risk per trade, and it is sobering.

The Holy Grail trap

Despite all of this being well proven, most new clients arrive spending the majority of their time hunting the Holy Grail: the perfect entry indicator. The silver bullet that gets them in right at the bottom of the trend and out right at the exact top, and, best of all, is apparently guaranteed.

I don't like disappointing people, but I have to tell them two things. Firstly, there is no Holy Grail. No perfect indicator exists. Secondly, even if it did, it wouldn't matter as much as they think, because it's not when you buy or when you sell that determines how much money you make. It's how much you put into the trade.

An example

Say my system gives me a buy on stock XYZ at one dollar, and I exit at two dollars. I've made a dollar a share, 100 percent profit. But what determines how much money I actually banked? Not the entry, not the exit: how much I put into the stock. And the same goes for losing trades. What determines how much I lose is not when I sold, it's how much I had in the position. That is why money management matters so much, and why a volatility-based exit like the Average True Range stop is only half the equation.

Van Tharp's breakdown

There's a great book on this: Trade Your Way to Financial Freedom by Dr Van Tharp, a psychologist who researched the most successful traders to find out what made them successful. If you haven't read it, I recommend you do.

Through that research he broke trading success into three components:

• System: 10 percent. The entry and exit conditions. The thing most people spend most of their time on is the least important component.
• Money management: 30 percent. The rules and guidelines that define your risk in the market.
• Psychology: 60 percent. This may sound airy fairy, but his reasoning is hard to argue with: give someone a perfect system and perfect money management, and they only succeed if they have the discipline to follow it.

Most people fall down here because they don't approach the market in a systematic fashion. That's what a written trading plan is for, and why you stick to it. I know I've ranted a little, but it's vital you spend the majority of your time constructing good money management rules, not chasing entries. A decent charting package handles the calculation side; the rules are yours to set.