Money Management in Day Trading


Majority of people who enter trading start with the thinking that all they have to do is to make a good entry, and then sell at some handsome profit. That’s all there is to trading. After first hand experience of being in some loss making trades and seeing losses go out of control, they come to realize that probably all is not well with their understanding or technique. They often conclude that the losses are due to their imperfect technique of entry, so they spend considerable effort looking for some “perfect indicator”.

This perfect indicator is not only going to help them enter right at the beginning of the trend, but it’s also going to get them out at the exact exit point. This way, they’ll make the maximum possible money from each trade. At this point the search begins; traders enter the technical world of trading and find that there is plenty of latest stuff on offer.

Technical indicators have the quality of attracting and employing curious people of all hue and shades. After spending heavily – both in terms of time and money – every trader comes to the same conclusion: a perfect indicator does not exist. Moreover, all indicators have a major handicap – they can’t tell you how much money to put in a trade.

With whatever technical knowledge acquired by now, they still find themselves that all is still not well with their trading. By now most have already lost their trading capital and quit. Some brave ones still continue battling, now armed with technical knowledge and conviction that their desire to succeed would ultimately see them through. Only a handful come to the conclusion that they are missing something more fundamental. They find that they lack a comprehensive strategy to succeed in trading, ie., they need to approach the trading business from a wider perspective – which is money management. Most people fail because they do not approach trading in a systematic way, and that’s where a trading money management plan comes into picture.

What is money management

Good money management is to set up rules allowing you to trade with the right amount of acceptable risk with maximum returns. There are four basic issues a trader has to consider: When to enter, when to exit from a losing trade, how to exit from a profitable trade, and the amount of money to be put in a trade. Trading money management revolves around managing the later two – exit and trade size – which directly affect profit and loss. Entry and the initial stop loss is normally left to the trading system. Putting it more comprehensively, it is all about setting rules and guidelines that keep your risk at a level that you’re comfortable with.

Having a proper money management system helps you in two significant ways: one, to make your trading systematic, consistent and disciplined, and two, to keep your emotional involvement away which is a major hurdle in successful trading. While money management cannot ensure that you always make spectacular returns, but it can help you maximize your profits on winning trades and minimize your losses on losing trades. The basic framework of money management is provided by the following four issues.

1.  Limiting maximum risk per trade

“A good trader watches his capital as carefully as a professional scuba diver watches his air supply.” – Dr Alexander Elder

"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."  – Larry Hite

In the heart of money management rules lies the idea of capital preservation. It necessarily implies limiting losses and maximizing profits opportunities. Thus, the money management guidelines should keep your thought process in the realistic direction. The key to success in the day-trading game is to avoid heavy loss on any single trade.

What percentage of the total trading capital should be risked on any one trade – this is the most important decision you need to make even before entering a trade. Top traders keep this in the 1 – 2 % range; it provides safety against a streak of losses which are a normal part of trading life. At 2% risk, 50 consecutive losses will be required to wipe out your trading capital – a highly improbable scenario. It is better to keep this percentage fixed so that your trade size varies reflecting the total capital at any time. Along with stop loss size, this decides the trade size as will be shown later in the article position sizing.

Others also put limits on daily losses (say, not more than 3%) and monthly losses (say, not more than 6%). You not only need to set your own loss limits, but also stick to them religiously if you seriously wish to succeed.

2.  Limiting trading risk – Stop loss size

The location of stop loss order must be decided before taking a trade to safeguard against the possibility of the trade going bad. There are ways to decide the stop loss size as will be seen in another article about stop orders. After you have fixed your maximum loss per trade (as discussed in lines above), the stop location becomes critical in deciding the position size.

Never move a stop backwards. If your stop is getting hit frequently, re-examine the rules of the system – don’t mess with money. Take your losses when they are small.

3.  Decide size of the trade – position sizing

Based on the two loss limits as described above, calculation of trade size is straight forward. Let us see it through an example, but first we need to define the parameters of the trade.

Assume that we want to buy a share, ABC, priced at Rs. 60.
Our total trading capital is Rs. 50,000.
Our maximum risk on the trade will be 1%.
Stop loss will be placed at Rs. 55.

To calculate the position size, we proceed as follows:
1% of 50,000 is 500.
Risk per share = 60 – 55 = 5.
#share of ABC to buy = 500 / 5 = 100.
Trade size = 100 x 60 = Rs. 6,000.

So, you will only buy 100 shares of ABC for Rs. 6,000. If the trade goes bad, you will exit at Rs. 55 losing only Rs. 500.

What if you decide to place your stop at Rs. 57, risking Rs. 3 per share. Now

#share = 500 / 3 = 166.7 (rounded to 167)
Trade size = 167 x 60 = 10,020.

Although now you are putting in Rs. 10,020, your risk still remains Rs. 500 (1% of trading account). Experienced traders carefully study the market condition and price volatility to decide the optimum location of the initial stop order and size the position accordingly.

4.  Allow profits to grow -- trade management

As your trade evolves, you need to track it carefully. And there is a very good reason for it -- markets are notorious for taking sudden nasty turns. Let us consider again the above trade where you bought 100 shares of ABC at Rs. 60 with initial stop order at Rs. 55. What should you do if moves to Rs. 75? It is important to adjust your stop prices as the trade moves in your favor. Your total equity has now gained Rs. 1500 and your total trading capital has appreciated to Rs. 51,500. If you leave the stop at 55 (now your risk per share has become Rs. 20!) and market turns around, your loss will no longer be 1%; it will be 3.9%. (Check it for yourself)

Leaving stop unchanged is a common bad habit. If losing 1% of the trading capital is bad enough for you, losing 4% should be unbearable. Moving stop with the price is a healthy habit: It locks in your profits and maintains the discipline of keeping loss per trade to the specified 1% risk.

However, do not trail the price too closely. Allow room for usual volatility to avoid getting out unnecessarily. For example, you may place the trailing stop order at Rs. 70, securing a profit of Rs. 15 and risking Rs. 5 per share for sake of further growth in profits. This brings your risk to within 1% of the present total capital.

Some traders prefer to take partial profits as the trade goes in the positive direction. It is known as scaling out. For instance, when 40% of profit target is achieved, one third of the holding is sold out, at 70% of the target another 40% is sold, and finally the remaining 20% is exited through trailing stop order. One can devise his own strategy depending upon the market conditions and personal preference.
 
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