Trading with Money Management

Expectancy

At this point I hope you are realizing that if you are going to be part of the elite, and are able to be consistently profitable year after year, there is much more to trading then simply finding a good way to enter the market.

Calculating your expectancy gives you a good idea of how much your system should make based on a given number of trades. Expectancy is the return per dollar risked. To be able to figure out your expectancy you also need to know a little bit about how your system performs. This is the one advantage in buying a system vs building your own, if you are buying a credible system, generally you will also have the trade stats that the system has produced. This data will be useful in determining just how well it will perform, and more importantly how well it performs vs another system. After all, you have a limited amount of resources, you want to maximize your return on equity.

Determining your systems expectancy allows you to see it's overall performance, but more importantly it creates a metric to compare systems against each other.

This is the information needed about your system before you can calculate it's expectancy and evaluate it:

Winning %, also know as Reliability or Hit Rate
Cost of Trading, this includes things such as commissions, slippage, and any other per trade cost
Monthly Trade Opportunity, how many Valid trades will you be able to take in an average month
Size of Trading Capital, this is the entire trading account, not the amount to risk per trade
Position Size, how much of your capital are you risking per trade
Average Winning Trade, the average of all winning trades
Average Losing Trade, the average of all losing trades

The Calculation:

Expectancy = (Winning % x Average Winning Trade) - (Losing % x Average Losing Trade)

Example:

Winning % = 42%
Cost of Trading = $12
Monthly Trade Opportunity =10
Size of Trading Capital = $20,000
Position Size = 2%
Average Winning Trade = $432
Average Losing Trade = $267

So my expectancy with the above data would be, 0.27 = (.42 x 432) - (.58 x 267)

You would then multiply your expectancy times your monthly trading opportunity times your $ amount risked to approximate monthly gains. Then multiply your cost of trading times your monthly trade opportunity to get approx monthly expenses. Subtract the two figures to come up with your ave. monthly return. Again, if you don't want to do the math, download the calculator.

((0.27 x 10) x (400)) - (10 x 12) = 960

So in this example, with this system, your average monthly return should be $960.00

What does this mean?

This mean's that based on the systems performance, I should expect to make 27 cents per dollar risked. So you now have a metric for comparing systems performance. Keep in mind that you are evaluating past history and that means the greater number of trades that make up your systems data the more accurate it will be.

The Value of TIME

Now, the next thing you need to evaluate is what is the Monthly Trading Opportunity, in the above example our system makes an average of 10 trades per month. What if you were comparing this system to another system that traded 20 times per month but only had an expectancy of 0.25 instead of 0.27, which would you choose? I hope you took the 0.25 as it would put significantly more money in your account by the end of the year due to the fact that it is turning your money over much quicker.

I have found it much easier to incorporate everything involved into an estimated monthly return, that way after inputing all of the data, I can just select the system with the largest monthly return, all things being equal.

To Fully Understand this Key Concept read Trade Your Way to Financial Freedom

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The 2% Rule

Key Concepts

The 2% Rule

The 2% rule is a basic rule that should be integrated with your money management system that says: You should never risk more than 2% of your total account value on any single trade.

Now, before you misunderstand and blow off this important rule, let me clarify through example:

Suppose you have a $100,000 account, to keep it simple. You are then allowed to risk $2,000 per trade. Now, does that mean you can only buy $2,000 worth of stock, if you are a stock trader? NO!! It means you are only allowed to lose $2,000. So in effect what the rule does is forces you to think through your stop loss level before you ever put on a trade (a must in money management).

Here's an example:

Let's say, for some reason, I though price was going to continue higher, it has traded slightly below that trend line, and I want to get in before it makes a move higher. However if I'm wrong, I cannot risk more than 2% of my trading capital, in this example $2000. The current Price is 530.40, but I want to make sure it's going in my direction before I enter the trade, so I enter a Buy Stop order at 531.00. That means when price trades at or above 531.00, my order will be filled at market. I also decide that if my price triggers and then the market moves against me, I don't want to be in the position if price gets down to 529.00. It is important to place your exit in a logical location. You don't want to randomly pick a spot that has a high chance of getting hit my normal market noise.

Contract Calculation:

Entry Price: 531.00

Exit Price(loss): 529.00

Net loss: $2.00 (531-529=2)

Contract value per point: $100

Net loss per contract: $200 (2 x 100=200)

Maximum number of contracts that can be purchased: 10 ($2000/$200=10)

So based on the calculations, you are allowed to purchase a maximum of 10 contract and if the trade goes against you, you will not be risking more than 2% of your account. Now these calculations don't include the cost of commission or slippage in order to keep it simple. but a good rule of thumb is to always trade less than the maximum, perhaps 8 contracts, so your commission and slippage plus your loss never amounts to over 2%

Don't let the above calculation confuse you if you are trading stock, here's how to do it:

Stock Calculation:

Entry Price: 531.00
Exit Price(loss): 529.00

Net loss: $2.00 (531-529=2)

Maximum number of shares that can be purchased: 1000 ($2000/$2=1000)

This simple rule starts the building blocks for successful money management. It forces you to think through an area with great precision that most traders flat out ignore, THE LOSS. It is the loss that will destroy you, not the gains, if you only allow your account to suffer small losses, than a few large gains will be enough to put you ahead. More importantly, you are starting to set yourself up in a position where you can be right less than half of the time and still make money!.

To Fully Understand this Key Concept read Sell and Sell Short

Last Updated ( Tuesday, 04 November 2008 22:22 )