What if I was willing to risk $1 with the potential to make $1 and I was right 6 out of 10 times? That means 4 times, I'll lose $1 (for a total of $4 lost) and 6 times I'll make $1 (for a total of $6 gained). Out of 10 trades, I would make $2. On 10 trades risking $1 each time, how much have I risked? A total of $10. If I make $2 for every $10 risked, that's 20% return on my risk.
The above money management example was based on a number of assumptions.
This last assumption seems the most obvious and yet is the place where most of us get tripped up. I can't over emphasize this enough (and I say this from experience). The money management rules MUST be followed consistently or one day you will experience a serious shakeup. The kind that could either put you out of the game or cause you to wake up and take your rules more seriously. I'll save a longer rant for another page. But... please develop the discipline to follow your rules consistently.
Up to this point, I've talked a little more theoretically about money management. Let's get down to more practical application.
Depending on what resources you consult, the experts (the ones who have survived in this game for a while) will tell you not to risk more than 1-3% of your trading capital on any one trade. If you've read any of my trading strategies, you may have noted that I've consistently used a maximum loss amount of $1000. That was based on an assumption of trading a $50,000 account and risking just 2%. This is the key part of my money management plan.
What amount should you risk? How much of a loss can you tolerate on any given trade before it keeps you up at night. Don't use a % value until you've converted it to a dollar amount. A % gain or loss won't keep you up at night. Potentially losing $5000 on a trade might.
I've actually found that the larger my account is, the lower my percentage I'm willing to risk on a trade. Why? Because I don't like the idea of losing such a large amount on the trade. This makes me do things like break my trading rules.
Just to be clear then, I would decide on a percentage amount I am willing to risk on each trade. This helps guarantee that my risk amount is sized up or down as my account grows or shrinks.
Once I know what the equivalent dollar amount is for the percentage I am risking, I can then decide how large of a position I can take. Let's say on a given trade, I am risking $.65 per contract (or $65) and I have a $10,000 account I am willing to risk $2% per trade on. The position size would be determined by dividing $65 into my 2% ($200) risk. $200/$65 = 3.07. Whoops... we can't take partial contract sizes. Do we round up or down? You will have to define the rule for that. HINT: A more conservative trader would probaly round down. A more agressive trader might choose to round up any fraction larger than .5.
Once I know how much I will allocate for each trade, I also need to define how much I will risk for a given strategy or set of strategies (for example options trading strategies as opposed to stock strategies). What would happen if I were to place 10 trades in a row risking $200 on each one and they all turned into losers? Could it happen? Of course it could. It may not be likely, but it is a possibility that needs to be considered. Ten trades each losing $200 is $2000 lost. If I was trading a $10,000 account, I just lost 20% of my account. Can I tolerate that?
This is why a maximum percentage risked should be used. So, in addition to risking 2% per trade, I might decide I only want to risk 10% total on income generating options strategies. That means I can only have 5 total trades operating simultaneously.
Let's face it. If the market of 2008-2009 has shown us anything, it's that anything can happen. With that in mind, I have to also have decided how much I'm willing to risk overall in the market. This may not be as important if I'm only dealing with $10,000, but when I reach larger amounts, distributing my risk across various markets (stocks, options, real estate, bonds, etc) is a great idea.
With that in mind, I then also need to be thinking about how much of my net worth do I allocate to riskier investments like stocks and options. If I'm younger, I may be able to tolerate risk. As I grow older and closer to my retirement, my tolerance for risking my entire net worth should greatly diminish.
With this in mind, the following list of questions should act as a starting point for determining your own money management rules.