Money Management

“The best traders are not right more than they are wrong. They are better at getting right when they are wrong.” Lloyd Blankfein, CEO Goldman Sachs

If there is a “holy grail” in trading it is money management. Most traders spend all their time looking for the holy grail of technical indicators which will magically tell them when to enter trades with profitable results. Such an indicator does not, nor will it ever, exist.
Our trading plan must have a positive expectancy or it will ultimately fail. We track and review expectancy by monitoring our risk reward ratio, average trade result, and the plans expectancy as calculated by the Dr. Van Tharp methodology.

The basic theme of money management for traders is to cut your losers quickly and let your winners run. This is true for intraday, swing, and long term trading. To do this with intraday trading is probably the hardest as the trader is programmed to act quickly. The quick stop loss exit is fine; the quick profit exit is deadly.

So the “holy grail” then is to find the right parameters for exiting the trade, not entering the trade. There are many good systems (indicators) to get you into a position; the hard part is the exit. We have determined 3 possible exits for our trade plan, the hard stop, the break even stop, and the profit stop. The way we handle these 3 exits will determine the profitability of the system. The hard stop must be small enough to cut the loser quickly but large enough to give the trade “room”. The break even stop must save against reversal but also give the trade room to oscillate. The profit stop must allow that same oscillation, not giving back huge MFE while also letting the winner run.

All the exit possibilities run on a fine line that cannot be broken by the trader’s emotional responses. They require thorough statistical analysis in order to find that line and determine when the line moves in order to respond appropriately.

Hard Stop

The hard stop provides the trader with the first half of the money management holy grail; cut your losers quickly.

If you cannot take and accept stop losses you cannot be a trader. Stop losses are best viewed as business expenses rather than money lost. All businesses have expenses and in the trading business this will be your largest expense. Therefore like any business that expense must be managed and constantly evaluated for ways to reduce it. Stop losses have also been described as an inventory purchase, when you take a loss it is like buying inventory (cost of goods) and when you have a winning trade you have then sold that inventory for a profit. These analogies only work if your wins are larger than your losses. You can’t buy widgets for $2.00 and sell them for $1.00 and expect to stay in business.

The hard stop value is set as a % of the range bar we are trading. We are currently using 75% of the range bar as our hard stop. With a 16 tick range bar our hard stop would be 12 ticks. This allows some heat in the trade but as we are trading momentum we expect the trade to move our way quickly. If it is not moving our way we do not want to be in the position and the hard stop will take us out. This stop is set with our front end and requires no action on our part after the trade has been entered.

We never increase this stop once the trade is in place and will tighten the stop with 1 bar completed after entry to 1 tick below / above the low / high of the move after entry.

Break Even Stop

This stop is in place as a precaution against the momentum working for us for a short period and then reversing against us. As we do not know which trades will ultimately work for us we have to enter all that meet our parameters and we know a % of these will move our way and then reverse on us. The break even stop protects capital against a reversal in the trade.

The BE stop also provides us “emotional capital” to help us stay in a winning trade longer as we know that after we move the stop to BE we can no longer lose money on this trade. We move our stop to BE + 1 (the 1 tick pays the commission) after we have had the equivalent of the range bar being traded in positive ticks in the trade. For example with a 16 tick range bar we move to BE + 1 after 16 MFE (maximum favorable excursion) in the
trade. This stop is set with our front end and requires no action on our part.

Profit Stop

The profit stop provides the trader with the second half of the money management holy grail; let your winners run.

Only in trading could a profit make you feel bad. Even with money in the bank the trader will look back on the trade and ask could he have made more money if he had held longer or exited quicker. In our experience the profit stop is the most difficult and perhaps the most important decision in the business. We have tested several different profit exits and continually track different exit potentials. We have found that a technical indicator exit will provide the most positive ticks in the long run. Other traders utilize targets for exits and this can provide better results over a short time period. The problem with a target is it will miss the “whale”, the one trade that runs $1000 or more. These big winning trades don’t occur that often but provide the trader with the bulk of their profits in the long run.

We do believe that a multi contract system with one contract coming off at a target and the other allowed to run to a technical exit is probably the best of both worlds.

The best results we have seen to date is the ADX momentum reversal exit. We also begin trailing the profit stop at 50 MFE and this is done automatically by the front end.