Thursday, July 21, 2011

Money Management

Trading risk management are simply a set of principles you follow to keep your risk at a level with which you are comfortable. There are essentially four components to setting excellent trading risk management rules Let's look at each of them in turn.

Trading float
Maximum loss
Initial stops
Trade size

TRADING FLOAT: Determine how much money you set aside for trading. Remember, the more you trade with, the more you stand to win or lose. This decision needs to be based on your overall trading goals, while recognising your other financial commitments outside of trading.

MAXIMUM LOSS:  Determine the maximum amount of capital you are prepared to lose in one trade. Like the professional poker player I met, you might set your limit at 2%. In Market Wizard Larry Lite recommends not going beyond 1%. Other professional traders say 0.25%. You need to find the sweet spot to match your trading float.     

INITIAL STOPS:  Set a predefined point at which you admit defeat and exit the trade.When you enter a position, you never know where you are in the trend. The trend might be in the middle of its run or at its end. That's why you must set your initial stop. It's like saying, ‘If a particular trade doesn't do what I thought it would, I'm going to get out.’Generally, short-term traders will set their stops closer to the price, while longer term traders tend to give their trades a little more room to move. Note: by setting your stop losses too tight, you'll decrease the reliability of your system because you'll get stopped out more often. Plus, the more you're in and out of trades, the higher your transaction costs. There are many ways to set initial stops, such as technicals, indicators, percentages and more.Whatever you choose, the important thing is to just have something in place. Sure, you can always drive through that red light, but you risk getting wiped out by a semi-trailer!

TRADE SIZE:  After setting your initial stop, you need a method for calculating your position size so you never risk more than your predefined maximum loss. There is a simple formula for calculating this:
maximum loss / initial stop size = number of units to purchase.

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