What You Need To Know About Money Management

Money Management: Just Like Sex

So how much thought have you given to money management recently? Or are you still too preoccupied by all kinds of indicators or CNBC fundamental buy, sell and holds to focus on the subject? Eventually, however, you've got to ask yourself the most important question of all: "how much?" right? Getting a straight answer to that one may be tough. There's still a lot of confusion about risk or money management from so-called gurus. I recently saw the following comment regarding money management from a "guru": "(We) use very simple money management: Trade one contract per trading signal in the markets … with no pyramiding.

"This is NOT money management. When you hear someone describe money management like this trading guru, run don't walk the other direction as you are about to be conned. So if money management isn't some set amount of shares or contracts picked out of thin air, what is it? Money management answers the question of "how much?" At all times, given the risk you are taking, the money you have, and the volatility of the market -- you must know the optimal number of shares or contracts to be long or short. In my opinion money management or position sizing or bet sizing just doesn't get the attention it deserves. Gibbons Burke of www.markethistory.com observes: "Money management is like sex. Everyone does it one way or another, but not many like to talk about it and some do it better than others. But there's a big difference: Sex sites on the Web proliferate, while sites devoted to the art and science of money management are somewhat difficult to find."

Money management is ultimately a defensive concept. It keeps you in the game. For example, money management tells you whether you have enough new money to trade additional positions. Trend followers all realize that you need to make small bets initially to simply stay alive and play another day. So, if you start at $100,000, and you're going to risk 2 percent, that will be $2,000. You say to yourself, "Why am I only risking $2,000. That's nothing compared to what I've got to bet." But that's not the point. First things first. You can't predict where the trend is going to go, so you can't afford to risk all of your capital out of the gate. Trend follower Craig Pauley points out: "There are traders who are unwilling to risk more than 1% but I would find it surprising to hear of any trader who risks more than 5% of assets per trace. Bear in mind that risking too little doesn't give the market the opportunity to allow your profitable trade to occur."

Think about money management as you would about getting into physical shape. You can't lift weights six times a day for hours each day for 30 straight days without hurting yourself. There's an optimum amount of lifting you can do per day that gets you ahead without setting you back. You want to be at that optimal point just as you want to get to an optimal point with money management. Trend follower, Ed Seykota www.seykota.com, author of The Trading Tribe book, describes this optimal point with his concept of "heat". "Placing a trade with a predetermined stop-loss point can be compared to placing a bet. The more money risked, the larger the bet. Conservative betting produces conservative performance, while bold betting leads to spectacular ruin. A bold trader placing large bets feels pressure - or heat - from the volatility of the portfolio. A hot portfolio keeps more at risk than does a cold one. In portfolio management, we call the distributed bet size the heat of the portfolio."

Trading correctly is 90% money management, a fact that most people want to avoid or don't understand. However once you have money management down, your personal psychology will be 100% of your trading success. Once you have the rules, you still need to follow them! Why then do traders have such trouble keeping their trading proportional? Why is it so hard for them to find that optimal point? Fear. Trend follower Tom Basso points out that traders usually begin trading small and then as they get more confident increase their trading size. Once they get to a certain comfort level of say, 1000 contracts, they often stay there, suddenly fearful that turning up the "heat", to use Seykota's term, will increase their risk. For trend followers like Basso, the goal is to keep things on constant leverage. Few traders make the move to a proactive posture in which risks are actively managed for a more efficient use of capital.

How do you avoid trading less instead of trading the optimal amount at whatever capital you have? You need to create an abstract money world. Don't think about what money can buy. Just look at the numbers like you would when playing a board game like monopoly or risk. And since your capital is always changing, it's important to continually rebalance your portfolio. Trend follower Paul Mulvaney points out that, "Trend following is implicitly clear about dynamic re-balancing which is why I think successful traders appear to be fearless. Many hedge fund methodologies make risk management a separate endeavor. In Trend Following it is part of the internal logic of the investment process."

There it is: the key is a risk understanding. That's what money management is really all about. Managing risk. In "A Perspective on Risk" Jim Little & Sol Waksman take risk management a step further: "Sound investment policy is really about intelligent risk management. There is no such thing as a risk free investment. Even an investment in cash exposes the investor to the risk that his buying power will erode through inflation. The real issue is not whether you want to take risk, but which risks and how many of them you are willing to accept. To make intelligent decisions as to how much of a particular risk is right for you, and how to blend risks properly to lower overall portfolio risk, you must have accurate measurements about how much risk each sector of your portfolio is exposing you to. Some investors rely on conventional wisdom (or lack thereof) to dictate their asset allocation. Others rely upon outdated statistics. The wise investor continues to study the facts."

David Harding www.wintoncapital.com, the founder and CEO of Winton Capital also makes the clear case for thinking about risk: "It is a risk management business. An investor should be hiring us to take risk on their behalf, and we will take exactly the level of risk that they ask for. For example, if an investor has USD 10 million and asks us to produce annual variance of 1 per cent on that, we will do it and we will get it exactly right. In contrast, returns are not predictable!" And there's the rub for most people and most gurus. Money management or risk management is all about reality, and most people don't want to face something as hard as the real world. They'd rather predict or pretend. Which do you want to do?

Michael W. Covel is the founder and President of Trend Following™. A researcher of the most successful Trend Following investment managers, he has been in the alternative investments industry consulting on Trend Following to individual traders, hedge funds and banks for ten years. His best selling book, Trend Following: How Great Traders Make Millions in Up or Down Markets (Prentice Hall, May, 2004) is a complete and concise guide to trend following. It includes interviews with great trend followers who have won millions if not billions in the market. The trading world has embraced the book with endorsements from Van K. Tharp, John Mauldin, Ed Seykota and many more. Trend Following is now in its fifth printing, and is currently available in a Japanese translation with Chinese, German, French, Korean and Russian translations soon to follow. Teaching and sharing unique insights about Trend Following trading and alternative investments has earned Mr. Covel respect as a rational and logical voice in uncertain times. Mr. Covel also writes for numerous industry publications including Your Trading Edge, Stocks, Futures and Options Magazine and International Petroleum Finance and is consistently quoted and interviewed by a variety of financial publications.

Mr. Covel is also Managing Editor at TurtleTrader.com®, the leading Trend Following news and commentary resource since 1996. Thousands of visitors from more than 70 countries as well as hundreds of trading professionals engaged in years of debate and interchange making the site the rich archive of trading information, data and opinion that it continues to be today. TurtleTrader, one of the largest & strongest trading community on the web with over 7.5 million unique visitors since its inception, also functions as a resource center for the Trend Following Educational Course.