Money Management - A Professional Day Trader's Perspective On Money Management

The term "money management" is often not clearly defined for traders. The term can refer to risk, capital protection, stop loss orders or position sizing depending on who is using it and in what context. All those topics could easily be included under the heading of "money management" but it is not helpful if we cannot understand what our responsibilities are when dealing with "money management".

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Otherwise, on with the show...

As traders we like clear lines, easily separated parts to our trading strategy so a term that is not clearly defined does not help us become good traders.

Let me share with you how I apply money management to my trading. Hopefully you will be able to use the following concept to clearly define your changing roles as a trader and do the right things at the right time during the course of a trade. In the course of a trade you are firstly the initiator and then a defender. In sporting terms you play offence first and then play defence. You play offence to initiate a trade and play defence to defend your profits or capital.

To begin let me explain how a trading system is structured. A trading system is structured in two parts. The first part is the ‘strategy.’ In a trading system the strategic part of the system defines when and where an entry will be executed. This is the action step to open a position. Once a position is taken a trader is exposed to the movement of the market. If he has picked the direction correctly the trader will show a profit quickly, if he has not picked the direction correctly the trader will quickly show a loss.

This is the important point, when a trader is not exposed to the movement of the market he doesn’t need money management, why would he, after all the money is in his pocket. It is only when the trader is exposed that he needs so called money management but what does that mean?

Money management is simply how you are going to exit the trade. Money management is your exit strategy.

Most traders spend all their time designing entry strategies when in fact the entry is the least important part of any system. It is the exit that determines if you take a profit, a loss or scratch the trade. The entry has nothing to do with your success.

Here is a profitable strategy for you:

If the market is trending up, buy it. If the market is trending down, sell it. If the market moves against you after you have opened your position, close out. If the market continues to move in your favour hold your position until you are happy with the amount of profit you have accrued and close out your position.

Notice that you have only one decision to enter and that is to buy or sell. Notice also that once you have entered a trade you can only exit. The exit is your money management strategy.

When exiting a trade you also have a number of choices. You can have a profit or a loss. Profits are easy; we will take them big or small. Losses are another matter. There is no trader in the world who should take a big loss in any situation. Taking big losses is not good trading. Big losses are too hard to recover from so don’t take them. Every trader can live with small losses. That’s trading.

Think of a trade this way, when you enter a trade the market should move in your favour immediately. If you get long the market should move upward immediately after you enter the trade, if it doesn’t you are wrong and should get out. The same applies to getting short, if the market does not fall immediately after you sell into the market you should close your position because you are wrong.

Make no mistake, your exits determine your success as a trader not your entries. You can use a fancy title like ‘money management’ if you wish but in reality it is nothing more than using exits to protect your capital and your profits.