After finding a strategy with positive Expectancy and good opportunity, you are ready to use the weapon of money management (MM).
MM is relevant to all forms of trading, but it is particularly powerful in short term futures trading. It is the tool that utilizes LEVERAGE to dramatically accelerate the growth of your account.
Leverage is a double edged sword and must be treated with respect. But there is little point in choosing futures as your investment vehicle if you are not prepared to use it (with due caution).
MM comes in several different flavours, but I am going to focus on one technique known as the "fixed percentage" method.
In this method, the trader calculates a fixed percentage of available capital prior to entering a trade, then divides this by the risk amount in the trade to determine how many contracts to enter.
For example, if capital is $8,000, the chosen fixed percentage is 5% ($400), and the risk per contract is $175, then you would use 2 contracts ($175 into $400 goes 2 times).
The biggest decision you have to make is to choose the percentage. The larger the percentage, the greater the leverage. The greater the leverage, the greater the risk of ruin. Obviously, if you risk 20% on each trade, a run of 3 or 4 consecutive losses will decimate the account. However, the same bad run would not have a major impact if you risk 2.5% per trade.
Professional money managers with large accounts usually choose 2.5% or less. Given a strategy with a positive expectancy, this keeps the risk of ruin very close to zero.
A trader with a small account may need to choose a higher percentage to accelerate earnings. Doing so introduces a significant risk of ruin which gets bigger as the percentage increases.
To illustrate the power of MM, look at a series of results from a simple trading strategy in the soybean markets. Example 1 shows the results of using the strategy with a fixed percentage of 2.5% and a starting capital of $4,000. Notice that the number of contracts never gets above 1 implying that MM is not effective in this period. Nevertheless, growth is impressive with the initial capital of $4,000 growing to $6,738 (68%).
[Note: The spreadsheet assumes that a base amount of $2,000 is required to fund a trading account, and only calculates a fixed percentage on amounts in excess of this. It will always trade at least 1 contract, so long as there is a balance greater than $2,000.]
Example 2 shows the same period and same starting capital traded with a fixed percentage of 10%. Now the account grows to $10,812 (170%).
For anybody courageous or reckless enough to trade the account with a fixed percentage risk of 20%, Example 3 shows that the account grows to $18,700 (367%).
Notice that these results were based on a trading period of less than 3 months from 6th February to 26th March, 2007. You can see that the annualized returns are staggering.
Despite the mouthwatering returns from higher fixed percentages, statistics always catch up with you in the end. If you trade long enough, you will encounter a sequence of trades which will ruin you.
So, if you have got away with using a high percentage to successfully grow your account to a reasonable amount, consider adopting one of the following options as a matter of urgency:
- Reduce the fixed percentage to 2.5% or less.
- Withdraw most of your profits, and start building up from the small capital base again. Keep enough back in your savings to re-fund the account, if necessary.
Email me at the address shown on my website if you would like a copy of the spreadsheet.
David Bennett is an independent Futures Trader. He lives on the Gold Coast of Australia, trading financial and grains futures contracts in Chicago. Visit http://12oclocktrades.com for more articles.
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