Money Management : Rules Of The Road

In the first installment of this series we stressed the importance of money management, illustrated through drawdown and percent to recover analysis. We mentioned that money management ranges from simple, commonsense approaches to complex portfolio theory.
The good news is that for most traders money management can be a matter of common sense rather than rocket science. Below are some general guidelines that should help your long-term trading success.
1. Risk only a small percentage of total equity on each trade, preferably no more than 2% of your portfolio value. I know of two traders who have been actively trading for over 15 years, both of whom have amassed small fortunes during this time. In fact, both have paid for their dream homes with cash out of their trading accounts. I was amazed to find out that one rarely trades over 1,000 shares of stock and the other rarely trades more than two or three futures contracts at a time. Both use extremely tight stops and risk less than 1% per trade.
Use real stop orders—“mental stop” don’t work
2. Limit your total portfolio risk to 20%. In other words, if you were stopped out on every open position in your account at the same time, you would still retain 80% of your original trading capital.
3. Keep your reward-to-risk ratio at a minimum of 2:1, and preferably 3:1 or higher. In other words, if you are risking 1 point on each trade, you should be making, on average, at least 2 points. An S&P futures system I recently saw did just the opposite: It risked 3 points to make only 1. That is, for every losing trade, it took 3 winners make up for it. The first drawdown (string of losses) would wipe out all of the trader's money.
4. Be realistic about the amount of risk required to properly trade a given market. For instance, don't kid yourself by thinking you are only risking a small amount if you are position trading (holding overnight) in a high-flying technology stock or a highly leveraged and volatile market like the S&P futures.
5. Understand the volatility of the market you are trading and adjust position size accordingly. That is, take smaller positions in more volatile stocks and futures. Also, be aware that volatility is constantly changing as markets heat up and cool off.
Never add to or “average down” a losing position
6. Understand position correlation. If you are long heating oil, crude oil and unleaded gas, in reality you do not have three positions. Because these markets are so highly correlated (meaning their price moves are very similar), you really have one position in energy with three times the risk of a single position. It would essentially be the same as trading three crude, three heating oil, or three unleaded gas contracts.
7. Lock in at least a portion of windfall profits. If you are fortunate enough to catch a substantial move in a short amount of time, liquidate at least part of your position. This is especially true for short-term trading, for which large gains are few and far between.
8. The more active a trader you are, the less you should risk per trade. Obviously, if you are making dozens of trades a day you can't afford to risk even 2% per trade--one really bad day could virtually wipe you out. Longer-term traders who may make three to four trades per year could risk more, say 3-5% per trade. Regardless of how active you are, just limit total portfolio risk to 20% (rule #2).
9. Make sure you are adequately capitalized. There is no "Holy Grail" in trading. However, if there was one, I think it would be having enough money to trade and taking small risks. These principles help you survive long enough to prosper. I know of many successful traders who wiped out small accounts early in their careers. It was only until they became adequately capitalized and took reasonable risks that they survived as long term traders.
This point can best be illustrated by analyzing mechanical systems (computer-generated signals that are 100% objective). Suppose the system has a historical drawdown of $10,000. You save up the bare minimum and begin trading the system. Almost immediately you encounter a string of losses that wipes out your account. The system then starts working again as you watch in frustration on the sidelines. You then save up the bare minimum and begin trading the system again. It then goes through another drawdown and once again wipes out your account.
Your "failure" had nothing to do with you or your system. It was solely the result of not being adequately capitalized. In reality, you should prepare for a "real-life" drawdown at least twice the size indicated in historical testing (and profits to be about half the amount indicated in testing). In the example above, you would want to have at least $20,000 in your trading account, and most likely more. If you would have started with three to five times the historical drawdown, ($30,000 to $50,000) you would have been able to weather the drawdowns and actually make money.
10. Never add to or "average down" a losing position. If you are wrong, admit it and get out. Two wrongs do not make a right.