There are three disciplines that every good trader must master Psychology, Trading Systems, and Money Management.
These are the three Ms defined by Alexander Elder: Mind, Money, and Method. The first one, Mind, refers to our mind, that is, our behavior, discipline, emotional control and ultimately applied psychology. Money means Money Management and refers to money management. It will tell us how much to buy and how much to sell and, finally, Method, which refers to the method, the trading system we are going to use, that is, when to buy and when to sell.
Of the three Ms, money management, also known as money management, bet sizing or position sizing is perhaps the most important, as it will help us to increase our profitability-risk ratios.
What is Money Management?
Let's define money management or money management as the mathematical algorithm that decides How much!! we are going to risk in the next operation depending on the total of our equity or capital available for trading.
In other words, how much we can invest depends on the money we have available and the overall result of our operation. At first glance, it doesn't seem like something complicated. It's a numbers game and simply answers the question of How much capital to place in the next position?
This is a decision that every investor has to make, whether they know what money management is or not. The difference is that in that case, it was probably an irrational decision and one that assumed a very high risk.
Let's see it with an example. Imagine that you have 10,000€ and a friend tells you that his cousin has heard that his sister knows someone who knows a lot about this and that the XYZ action is going to skyrocket (although as a trading system it seems ridiculous, it is one of the most used by beginners). Now I know what I'm going to buy, but How much!!!!, this is where money management comes in.
And that amount can be a lot, a little, or downright crazy depending on the size of the wallet.
A very common mistake is to think that money management is an exclusive field of wealth management. Any investor can benefit from these techniques which, moreover, can be applied to any strategy or trading system.
However, money management comes into action when we have already taken a position. That's why some say that before taking a position we are traders and when we are already in the market, we stop being traders and become money and risk managers.
Another way to define the idea of money management is that of Van K. Tharp, I leave you with his famous quote:
“Possibly, the biggest secret to success in Investing and Trading is proper money management. I call it “Secret” because few people seem to understand it, including many people who have written books on this topic.” Van K. Tharp
What is not Money Management in trading?
We have already defined money management and to clarify this idea, we are going to define what is NOT money management.
And it is normal to confuse the following concepts and ideas:
When to Buy and When to Sell
The decision of when to buy and when to sell depends on our trading system or our rule framework or our favorite fundamental ratio, but never on our available capital, never on our level of Equity so it is not money management.
Where to Place Our Protection Stops
The stop losses are an indispensable tool in the trader's arsenal and help us stay in the game, protecting our capital. However, the placement of stops is part of risk management or risk management, a different concept.
Most traders believe that money management involves knowing where to place stops, perhaps due to lack of information, perhaps due to lack of desire to delve into issues related to the risk of our operations. If I apply, for example, a stop loss of 200 euros on each of my orders in the future of the ibex-35, I am following a strategy that is not related to my total available capital or Equity, so it cannot be categorized as money management.
Let's see once again how Van K. Tharp expresses himself in this regard
“There are people who think they are doing “money management” by managing their ‘stop loss'. Controlling risk through maximum loss points or stop loss, is different from controlling risk through a “money management” strategy that controls the size of the position at all times.” Van K. Tharp
This is another concept misinterpreted by most traders, who consider pyramiding as a money management strategy. Technically, pyramiding involves using unrealized profits from a stock or commodity as collateral to open other positions with borrowed funds from our broker.
However, in the general sense in which the expression is used and in which we are going to use it in this explanation, pyramiding refers to increasing the size of our position as the market moves in our favor. The opposite of pyramiding would be averaging down (averaging down or cost averaging), that is, increasing the size of our position as the market goes against us.
Suppose we have bought 1,000 shares of Telefónica at 12 euros and the price begins to rise when it reaches 12.5 we buy another 1,000 shares and when it reaches 13 euros, we buy another 1,000, if we follow this strategy, we pyramiding our position. It is a highly recommended strategy but it has nothing to do with money management since the fact of increasing the position does not depend on our capital or equity, but on market conditions.
Equity Curve Trading
This term refers to implementing trading methods on the results curve instead of doing it on the quotes of a financial asset.
An example would be to apply a moving average to our capital and use this moving average in the traditional way. That is, if our Equity curve cuts the moving average in a downward direction, we assume that we are entering a DrawDown and, therefore, we stop the trading system until our results curve begins to rise and cuts the average in an upward direction. This is how DrawDown periods are avoided.
However, there is no mathematical study that proves that Equity Curve Trading generates a higher profitability-risk ratio in our trading plan.
Consecutive Series of Losses; “The Casino Player's Fallacy”
There is a widespread belief that, after a series of operations with losses, the probability of success in the next move increases and that, therefore, it is convenient to increase the capital of the next investment.
This may or may not be true in the world of trading, but for most random phenomena, like flipping a coin, it is not true. What the previous statement implies is that the probability of success in each investment is somehow influenced by the results of previous investments.
However, it is true that when investing in the stock market each operation may not be totally independent of the previous one. For example, if we use a range breakout system or moving averages, we may get a winner after several consecutive failures. The problem is that we will never know when we are going to benefit from an increase in the amount invested, so doing it as failures increase can lead us to incur a large loss and leave us without capital.
In summary, a winning trading system in which it seems quite simple to generate money, How many PhDs do you think ended up making money at the end of the game? Only 2 out of 40, 95% of the players ended up losing money in a game where they should have won.
Why? Mainly because of the gambler's fallacy and the absence of money management techniques. In addition to psychological issues such as greed and fear.
95% of the players lost money by exposing their accounts to excessive risk and this is what also happens in reality, 90-95% of traders lose money for not knowing the psychological aspects of trading, for not using money management strategies, and for not understanding that it is a game of probabilities.
Why is Money Management the Great Unknown?
If money management is so important, why do we find so few books and articles on the subject? Why for every book on money management are there 30 or 40 on trading systems? Why do specialized magazines dedicate less than 10% of their content to money management? Let's look at two reasons for this neglect.
It is, without a doubt, the most boring part of a trading plan. They are the mathematics of trading. Any book that addresses them will be full of tables, numbers, and formulas and its reading is not as simple as that of a book that teaches us how to enter and exit the market
According to this current, there is an internal order in the markets, known by a few, so all I need is to find that privileged minority and get that method, that formula, that indicator, and thus I will know in advance the movements that the market is going to make. Let's leave romantic stories for the cinema and focus on the reality of trading.
We live in a random world and trading is no exception. There is no internal order in the markets. All we need is to create a methodology with positive mathematical expectations and we know that this is possible.
One of the most common mistakes is to think that to benefit from money management it is necessary to already have good results. Nothing could be further from the truth. The time to use money management is right now.
“Traders believe that they do not need to incorporate money management strategies into their operations until a future moment that will come, which will be when they are making money. They need to test a trading system and see if it works before applying a money management strategy to it. This can be a very costly mistake in terms of opportunity cost.” Ryan Jones
The Three Phases of Money Management
Once we have our trading system and our money management strategy, the next logical step is to apply it in the markets to obtain a benefit from the work done. Ryan Jones in his book “The Trading Game”, distinguishes three well-differentiated phases through which our account will pass, regardless of the type of strategy used (Fixed-Ratio, Fixed-Fraction. Optimal f, Secure f, etc):
1. Sowing Phase or sowing phase (accumulation):
In this phase the account is at its lowest point, we start from the initial capital and start with a single contract. Here the trader will not see the favorable effects of the money management strategy and, in addition, will suffer the negative effects of asymmetric leverage, a term that we will define later when starting to add contracts. In summary, the results will be lower than those we would obtain by applying our trading system without money management.
2. Growing Phase or growth phase.
In this second phase, the effects of the strategy begin to be seen, the effect of asymmetric leverage decreases and reaches a point where even if the trading system is not efficient, our account will show profits.
3. Harvest Phase or harvesting phase.
In this final phase is when our account shows the virtues of our money management strategy. Asymmetric leverage is history and we are at a point of no return to losses, that is, if our system starts to lose money our account will not be affected and the capital will be preserved. If you have had patience and discipline with your trading system and your money management strategy, this is the time to reap the fruits of well-done work.
Best Money Management Platform
To carry out an efficient management of capital it is essential to have tools and high-quality money management platforms.
Therefore, when choosing the best money management platforms it is important to consider various aspects such as:
- User interface
- Integration with other financial services
- Data security
- Quality of customer support.
In this sense, one of the most outstanding options is the trading platform ProRealTime. A platform that offers specific functionalities and unique advantages for investors, such as screeners, favorites portfolio of technical and fundamental analysis tools
Money Management Categories and Their Risks
All money management strategies can be classified into two categories.
In addition, these categories are not strategies in themselves, as many people think. For example, both Fixed-Ratio and Secure f, are actually strategies of the anti-martingale category.
The increase in the size of the bet after each loss is known as the Martingale Strategy.
It is an inefficient method, as it only works if we have unlimited capital. One of the clearest examples of how bad this strategy can be is the game that consists of flipping a coin and doubling the bet each time we are wrong. This game has zero expectations. It works as follows:
We bet 1 € with each coin toss. If it comes up heads we win 1 €, if it comes up tails we lose 1 €. If it comes up tails after the first play, we double the bet, so in the second throw, we bet 2 €. If we win, we win 2 €, if we lose, we lose 2 €. And so on.
The problem with this strategy comes when we face a very large losing streak. The amount bet also becomes very large. For example, after a streak of 10 failures, the next bet would have to be 1,024 € and in fact, 1,023 € has already been lost, so if we get it right on the eleventh throw our final gain will be 1€, while our potential loss increases too much. This type of game only succeeds if the player has unlimited capital, so let's leave these strategies for casinos, not for trading.
“The main problem of players is in finding a game with positive expectation. The player, in addition to this, needs to learn to manage the size of his bets, that is, money management. In financial markets the problem is similar, although more complex. The player, who is called Investor, seeks the maximization of the risk-return relationship.” Edward Thorp.
Anti-Martingale or Reverse-Martingale Strategies
In this category we are going to do the opposite with Martingale, after a winning operation we will increase the bet and before a losing operation we will reduce our bet, in this way we will protect our profits when the losing streak comes and we will let them run in the winning streaks.
These are the strategies that the trader should use. The most known and tested methods of the market belong to this category and the greatest risk of them is in the asymmetric leverage, which we will see next.
Equity Valuation Models
The different money management strategies refer to the total capital that the trading account yields. There are three ways to value that capital from which to develop as complex or sophisticated strategies as we want.
These three methods are Core Equity, Total Equity, and Reduced Total Equity.
This is how each one works:
- Core Equity Model: It is the simplest model of all, as it only takes into account the amount necessary to open a position. With it, our equity will be equal to the initial capital minus the initial amounts destined to each of the investments, regardless of how they are developing.
- Total Equity Model: According to this model, the level of equity is determined by the total available in cash plus the value of all open positions, whether these are positive or negative.
- Reduced Total Equity Model: This model is a combination of the previous two, and the calculation of the equity would be the following: When opening a position as in the Core Equity Model, we subtract that amount from the initial total, however, we do not leave it like that, and we add any amount that benefits from a stop loss that reduces our possible loss or guarantees a profit. It is the most complex model.
Remember that ProRealTime is a platform where you can test and monitor some of the money management strategies that we have seen here or redirected -toward the article in question-
This is an example of a trading account valuation for each model and what happens after seven different investments.
And this is what each movement means:
- We take a first position worth €5,000.
- We take a second position worth €4,000.
- Our first investment goes into the loss territory and is worth (€2,000).
- The second investment progresses as planned, becoming worth €6,000 and our trailing stop goes up ensuring a maximum loss of €1,000.
- The first position returns to the profit territory and now has a value of €11,000, and not only that, but our trailing stop now ensures us a profit of €8,000.
- We take a third position worth €6,000.
- In a final stroke of luck, our first position reaches our profit target and the €5,000 have turned into €12,000 so we close the position with a profit of €7,000.
In summary, success in trading is achieved through the mastery of three disciplines: Trading systems, Psychology, and Money management. If you want to become a good trader, you need to train and pay special attention to money management.
- Ryan Jones, “The Trading Game”, Wiley and Sons, 1999.
- Nauzer J. Balsara, “Money Management strategies for futures traders”, Wiley and Sons, 1992.
- Ralph Vince, “The mathematics of Money Management”, Wiley and Sons, 1992.
- Edward Thorp, “The mathematics of gambling”.
- Edward Thorp, “The Kelly criterion in blackjack, sports betting, and the stock market”, 1997.
- J. Edward Crowder, “Casino Gambling for fun and profit”, Writer’s Showcase, 2000.
- Van K. Tharp, “Trade your way to financial freedom”, McGraw-Hill, 1999.
- Van K. Tharp, “Special Report on Money Management”, IITM, 1997.
- David Stendahl, “Portfolio Analysis and Money Management workshop companion guide”.
- J. L. Kelly, “A new interpretation of information rate”, 1956.
- Burke Gibbons, “Managing your money”, Active Trader Magazine, 2000.
- Sherwin Kalt, “Probability of investment ruin”, S&C, 02/1985.
- Bob Pelletier, “Martingale Money Management”, S&C, 07/1988.
- James William Ferguson, “Martingales”, S&C, 02/1990.
- James William Ferguson, “Reverse Martingales”, S&C, 03/1990.
What are Martingale and Anti-Martingale strategies?
Answer: Martingale increases bet size after losses, risking large capital. Anti-Martingale increases bets after wins, protecting profits and reducing risk.
How can money management help beginner traders?
Money management aids in controlling risk and preventing emotional decisions, improving the overall trading experience.
What is the difference between money management and trading systems?
Money management focuses on position sizing and risk, while trading systems define when to enter and exit trades.