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Money Management - Part One

Money Management is the most important component of investing and trading.

Van Tharp (Definition):
Money management is that portion of your trading system that tells you “how many” or “how much.” How many units of your investment should you put on at a given time? How much risk should you be willing to take? Aside from your personal psychological issues, this is the most critical concept you need to tackle as a trader or investor.

“Risk management is the most important thing to be well understood. Undertrade, undertrade, undertrade is my second piece of advice. Whatever you think your position ought to be, cut it at least in half” - Bruce Kovner

“Never risk more than 1% of your total equity in any one trade. By risking 1 %, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical. ”
- Lamy Hite

“You have to minimize your losses and tv to preserve capital for those very few instances where you can make a lot in a very short period of time. what you can’t afford to do is throw away your capital on suboptimal trades. ” - Richard Dennis

NOTES:
From the above quotes, we can see that one of the most important success factor in trading or investing is "Patience". Most of the time, we are just too eagle to make the money fast and forget to follow our predetermined strategy. We always thought that we have found a short-cut. It ended up that it was our throat that was being cut. Remember the prices cannot go up forever, it will at one time stop or reverse.

RISK MANAGEMENT METHODS
Professional gamblers can use Martingale or Anti-Martingale system to trade:

Martingale:
Double your trade each time you lose until you finally won. However, there are 2 problems:
1. Limited resources. 2. The house impose limits on bet size.

Anti-Martingale:
Increase your trade when you win. Bet more on the wining trades and reduce losing trades. This involves also varying trade size as the previous case but within the limits.

Stop-Loss: This is not exactly money management but it is a tool that helps to reduce the risk and sets limits to your maximum loss. Using this tool you can set your risk limit.

MONEY MANAGEMENT MODELS:

Units per Fixed Amount of Money
In this model, you will decide for example, you can do one trade per $20,000 of capital or equity.

Equal Units Model or Equal Leverage Model
In this model, you divide your total capital into x equal parts and use that to buy different investments or asset classes.

Percentage of Margin
Depending on the margins allowed for each asset class, use that to decide the amount of holding in that asset class.

Percentage Volatility
Using price volatility of the product in conjunction with the percentage of total equity to limit your purchases. For example, using 5-day moving average of true volatility of gold to decide how many contracts to purchase. Example, volatility is $300 per contract. Your equity is $50K and risk allow is $1000 (2% of $50K) per trade . You can trade 3 contracts. Also, it will be important to limit the total volatility (sum of all trades) against your total capital.

Percentage of Risk
Similar to the Volatility Method above, this method uses Risk instead. For example, you plan to purchase GE at $45 and the support level is at $42. You will exit trade if it falls to $41. Your risk is $4. If you purchase 100 share, it will be $400. If your capital is $50,000 and percentage risk is 2%, you will be able to purchase 250 shares. Total risk will be $1000. $45 x 250 = $11,250.

Periodic Money Management Adjustments
As above but keep adjusting the risk buying or selling the contracts.

Group Control
One of the most important factors in risk control is having a diversified portfolio. Trading a number of items generally spreads your risk around, provided that price changes in those items have a low correlation.
By Trading different instruments, you will be able to get the benefits of diversifications.

Portfolio Heat
Maximum of 25% risk of total portfolio exposure based on Kelly criteria.

Long versus Short Positions
Balancing long term holdings vs short term holdings.
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