Money Management in Day Trading
You will learn about the following concepts
- What is money management
- Why do you need it
- Expected return
- Probability of ruin
In the chapter “Money Management” of Trading Pedia’s Forex Trading Academy we discussed some of the key points in risk management when trading currencies, and most of those principles also apply in day trading, even if you are trading on a different market. In the current chapter we will add a few more terms and enrich our knowledge about money management.
Money management, as you can guess by its name, is all about managing the size of your positions, determining the size of your initial capital, estimating whether and how much to withdraw after a good series of wins in order to keep your account balance from growing beyond a point where you can easily control it etc. The core basis of money management is to help you maximize the return of your capital while protecting it.
Probably the most important task a novice trader faces when beginning to trade is not to lose his starting money in the first year. We know that becoming an accomplished trader requires years and years of experience which is earned only through practice. Therefore, it is of utmost importance for a trader to use a proper money management strategy in order to survive and “live to trade another day”.
In order to do that, each day trader must find a balance between his risk profile and return expectations and the amount of risk he is exposed at with each trade. For example, if you are a highly risk-prone person, you might want to risk 20% of your total capital with each trade, but as you can guess that is not a good idea. Some trading gurus risk a maximum of up to 6-8% of their capital per trade, which itself is immensely high, but given the fact they have 10-15+ years of experience and large amounts of backup money generally ensures their long-term success.
Another setback of committing too much money to a single trade worth considering are the so-called opportunity costs. These costs are stemming from the fact that when you lock your money in one trade, you wont have money to enter any other trade, thus missing on that alternative profit. Thus, each dollar you trade carries certain opportunity costs. Good traders know that and seek to minimize them by committing smaller amounts of money into single trades, thus always having free capital to capitalize on a reliable trade signal.
Although high risk exposure may be devastating, the opposite extreme is not a good option as well. If a trader enters positions with too little money, then his performance will suffer and the results may be discouraging as he misses on good opportunities. This is why you will see in most trading guides, including here, people advising you to risk between 1% and 2% of your trading capital per trade. Of course, if you are unsure at the start, you will enter smaller positions, but eventually you will reach that amount. It is crucial to remember that traders should always place themselves in their comfort zone, thus you need to risk as much as you think you can emotionally handle. Being unable to digest the higher risk exposure in a certain situation will lead to emotional distress and result in a hasty decision you might regret later.
Chance of bankruptcy and profit outlook
The worst thing that can happen to a novice trader, well actually to every trader but the more experienced ones will take it much more easy, is to see his account getting wiped. The chance of that happening can be calculated with a simple enough formula measuring the so-called Probability of Ruin. However, first we will need to pull out some statistical data from the traders performance, on which to base it. Using that same data we can calculate another key figure – the Expected Return.
Expected return is a number based on four values derived from your trading history, which shows how much money you can expect to make if you continue to trade using the same strategy and money management system. These four values are the following:
– the percentage of winning trades
– the gain on winning trades
– the percentage of losing trades
– the loss on losing trades
We can then use these four values to calculate the Expected Return as follows: % of winning trades X gain on winning trades – % of losing trades X loss on winning trades = Expected Return.
Lets say a trader has 55% winning trades, each of which earned him 1.2%, and 45% losers, each incurring 1% losses. His Expected Return would then be: 0.55 x 0.012 – 0.45 X 0.010 = 0.0021, or 0.21% average win per trade. Of course, all those calculations need to be based on a data base rich enough, so that the numbers are smoothed out. This means that in the long-term, if you keep trading the same way you were up to now, you will earn 0.21% per trade.
The second calculation of significance is the Probability of Ruin. As we said, it measures the chance of a trader wiping his account and, logically enough, it is also based on his performance. Here is how the formula looks like.
[(1-A)/(1+A)]^C = R, where
– A is the advantage on each trade, i.e. the percentage difference between winning and losing trades. In our case, it will be 10% or 0.1 (55% – 45%).
– C is the number of trades in an account. Lets assume that we are dividing our account into 20 equal parts today, as we are planning to enter 20 trades. Our Probability of Ruin calculation will therefore look as follows:
[(1-0.1)/(1+0.1)]^20 = [0.9/1.1]^20 = 0.018071595, or you stand a 1.8% chance of wiping your account with those 20 trades today.
Do not ignore it
Although at a first glance bankruptcy has a relatively small chance of occurring, it is nevertheless present and you might be unlucky enough to experience it. However, as evident by the calculation, by increasing the advantage (raising the number of winner trades opposed to losers) you will be exposed to lesser risk of ruin. Moreover, if you do the math yourself, you will see that the the smaller the number of trades, the bigger the probability of ruin is, and vice versa. Thus risking less and going into a larger of number will help you trade for longer.
Another detail you should consider is that this calculation is based on the assumption that the losing trades bring your account to zero, whereas you can protect yourself from incurring heavy losses by using protective stops. However, stop-loss orders wont help you against consistent account erosion, which is something you need to address by honing your trading skills and attaining better entry judgement.