Position size
The above sets out one way of approaching Money Management. I believe that this is an eminently practical way of approaching this extremely important area of trading. Now I want to say a few words about position size. Let us assume that you have just devised a new system and that your testing of this system has led you to believe that it is excellent. Let us also say that you have £100 000 of trading capital and that you can hardly wait for those megabucks of profit you are going to make – so off you go, at least 10 contracts right from the start. Right? No, wrong! Paper trading is useful, testing is useful, but when you start to play for real the game changes, if only because you start to hit emotional/psychological problems you never even dreamt existed. These problems can be overcome but when you enter a new arena (i.e. actually trading your new system/approach) then you must minimize your risk – indeed good traders minimize risk at all times. So you don’t trade 10 contracts, you trade just one. And you keep trading just one until your actual results confirm that you should increase position size. At that point the area of risk (new territory) has become more quantified and you can move ahead without that being such a worry. It would then make sense to increase position size in appropriate steps. What you stand to gain from this approach is obvious. If your system had some flaws then you do not lose all your capital and you also develop some discipline along the way. What do you stand to lose? Just a little time. If all goes according to plan you may well be trading at the size you originally wanted to just a few months later – and in real terms that is nothing. What I find frustrating is that I can explain this to consultancy clients until I am blue in the face but then they often ignore the advice, go off over-trading, survive for a while, maybe even make some money, then that trade with their number comes along and its “adios amigo!”
Monitoring position
Another area where we can reduce risk is in careful monitoring of a position in the early stages. Sometimes when looking at a bar chart it is obvious where the market diverged from the expected path. Such divergence is a warning sign and often a very strong one. Indeed one factor I have noticed is that once a market diverges from a pattern that often a very strong move comes in the other way. The logic of this is fairly clear in that there will be plenty of traders, following the original signal, who will be caught out by just such a move. To an extent the need for careful monitoring will depend on your entry methodology and the logic/philosophy behind it. If you are looking for entries which ought to catch “unacceptable” prices then you would want such prices to be swiftly rejected by the market. The lack of such rejection might be a reason to exit a position. After all you are looking for the best opportunities and one which does not show such rejection may well not make that grade. Such things have to be related to each individual’s trading style and time frame. But this is where a real time price service can pay for itself. Signal, Tenfore, or Market Eye, for example, all cost considerably less than £300 per month and that is only 30 points on a FTSE futures contract. Of course then you need to be around to watch the screen, but the danger area is at the beginning of the trade. That is when you are most vulnerable, so it is really a question of monitoring the progress early on; once the trade has gone the right way traders can relax a little.
Stops can be a central feature of an MM system. There are various ways in which stops can be utilized and these will be covered in Chapter 15.
That concludes our brief resume of some of the more important points of MM, a subject of many books. But it should serve to prompt a few thoughts about how you might be able to improve your approach to the market.
SUMMARY
Good Money Management is the key to success. Without it even the best trading system would wipe you out.
A good MM approach means adopting a low risk approach to each trade. If you don’t do that it is a racing certainty that you will be wiped out.
Starting with a new system you must use just one contract until your results, i.e. profits, prove that it works for real.
Early and careful monitoring of a new position can minimize risk even more, but don’t be suckered out prematurely.
Chapter 8: RISK CONTROL
The traders who win are those who minimize risk. This is another key chapter and its importance is such that readers should read it carefully and ensure they understand its contents. Those who do not minimize risk inevitably pay the price and get wiped out.
It is for this reason that you often see strong moves after a news item is out of the way, often a news item suggesting a strong move in the opposite direction. The big traders, who got that way by minimizing risk in the first place, wait until the risk is at its lowest, when the news is out of the way.
Risk Control includes the following:
1 Not trading in too big a size, thus reducing the risk of a wipe out. Actually you should eliminate the risk of a wipe out .
2 Not holding overnight unless you have a profit buffer in place. However this does not apply to particular methodologies seeking to take advantage of certain factors which may apply to holding overnight.
3 Not holding over the weekend, subject to the same caveats as “2” above.
4 Taking appropriate action prior to major new items. This means not normally opening positions, maybe reducing position size if already positioned – although it does depend on your trading objectives.
But in markets there are two types of risk and we need to look at both. First there is the risk of loss inherent in the market itself. Second there is the risk of loss inherent in the vehicle we are trading. I deal with this in more detail later on (see Chapter 10), but simply put, the risk of making a losing trade when buying an option is far higher than when writing an option. But you can lose a lot more writing options, than you can buying them. This neatly demonstrates the two types of risk and, as traders, we need to understand how this works.
Risk inherent in the vehicle
First we will look at the risk inherent in the vehicle. This is really part of knowing your vehicles well and, as such, is part of the initial learning curve. If we take the example of buying a call option for 25 points. Our maximum loss is 25 points, we simply cannot lose more than that. So whatever happens we are safe, as long as that 25 points fits within our Money Management system. IBM, ICI, Microsoft and JP Morgan could all go bust and it would not make any difference. This is a very different situation to that in place if we had decided to go long either by writing put options, or by buying futures. In both those cases we would have lost point for point with the index futures (or whatever it was we were trading). Clearly a very different kettle of fish!
This gives rise to a useful point. As traders we want to keep as many options open as possible (I don’t mean market options in this context). In certain situations one trading vehicle may offer a better deal. For example a cheap option may make sense if we want to trade ahead of a news item. A pair of cheap options (i.e. a put and a call) may make sense if we expect a big move but do not know in which direction – I adopted this strategy the Friday before the 1987