MONEY MANAGEMENT –
THE MATHEMATICAL PROCESS OF INCREASING AND DECREASING THE NUMBER OF CONTRACTS/SHARES/OPTIONS. THE PURPOSE OF UTILIZING MONEY MANAGEMENT SHOULD BE TO INCREASE THE PROFITABILITY DURING POSITIVE RUNS AND PROTECT THOSE PROFITS DURING DRAWDOWNS OF ANY TRADING SYSTEM OR METHOD. Money management is what allowed Larry Williams to trade $10,000 into $1.1 million within one year. According to Larry, if he had traded ONE CONTRACT on every single trade, profits that year would have been only around $100,000. There were two aspects to Larry’s record setting trades: 1) The system and strategies he used to determine where to enter and exit trades; and 2) the method he used to increase and decrease the number of contracts to place on any given trade. To put it simply, only 9% of the total profits came from the system and strategies used to determine where to enter and exit trades while 91% of the total profits that year came from the money management strategy he applied. Money management alone increased Williams’ return by 1000%!
90% – 95% OF ALL TRADERS LOSE MONEY
This is a statistic that I have heard for years on many different occasions and from a number of reliable sources. In my own experiences hearing from other traders, I could not offer any data to the contrary. Here is another piece of interesting data I think is correlated to this statistic. 90% – 95% of all traders spend hundreds of hours and thousands of dollars trying to figure out where to enter and exit the market while they barely even put a thought towards how much risk to place on each trade and when to increase or decrease that risk. I seriously doubt that these two statistics are the same by coincidence. I opened the article by comparing two traders trading the same system. The first trader lost $3,000 during the year while another trade made $25,000 taking the same exact signals as the first trader. The difference between these two traders is the simple fact that the second one applied proper money management methods to the trades while the first one did not.
NOT JUST MONEY MANAGEMENT, BUT THE RIGHT MONEY MANAGEMENT
Before we further explore the power of money management, it is important to clarify that not just any money management should be applied to trading, but proper money management. To drive the point home, we will use the following illustration: Take a coin; toss it in the air 100 times. The ratio of heads to tails landing up should be very close to 50/50. If you were to win $2.00 every time the coin landed heads up and lose $1 every time heads landed face down, you should have won approximately $50 by the end of 100 tosses. This is a positive expectation situation. The odds of you winning are heavily in your favor. We will further say you have $100 to bet with. The question is, what percentage of your money should you risk on each flip of the coin? What would you say is the best percentage to reinvest on each flip? 10% 25% 40% of 51%? This means that if you begin with $100 and choose to risk 10% of your capital on each flip, you begin by risking $10 on the first flip. If the coin lands heads up, you win $20.
You would then risk $12 of the new $120 total on the next flip of the coin. If you lose, you lose $12 and if you win, you win $24 and so forth the game goes. Would it make a difference which % you used? If so, how much? Remember, you make twice as much when you win than when you lose. The odds of you winning are 50% every time. The answer may surprise you. By risking 10% of your money on each of the 100 flips (a $10 bet on the first flip) you will turn your $100 into $4,700! Money management increases your return from 50% to a 4700% return! Reinvesting 25% of your money would have turned $100 into $36,100! An increase of just 15% per toss increases your total return from 4700% to 36,100%.