Money management is a crucial part of a trading system, essentially determining the size of your position. It can determine how much profit you can make and how much risk you can take in system trades.
Section 1: The Importance of Money Management
People often say that successful trading = psychological control + money management + analytical system. However, in reality, most people overlook the issue of money management.
Let’s play a money management game: Let’s assume we have a game with a 60% win rate, starting with 1000 yuan and having 100 betting opportunities with odds of 1:1. How would you bet to maximize your returns? While reading the following, think about this question. Studies show that people tend to bet more when they are at a disadvantage and less when they are at an advantage. In the market, people often expect an increase after a few consecutive declines, or a decline after a few consecutive rises. But this is the gambler’s fallacy because the probability of a win is still 60%. At this point, money management becomes extremely important.
Suppose you start the game with 1000 yuan, and you lose three times in a row (which is statistically easy to happen), leaving you with only 700 yuan. Most people would think the fourth time will be a win, so they increase the bet to 300 yuan (hoping to recover the 300 yuan loss). Although the probability of losing four times in a row is low, it is still possible. Now you only have 400 yuan left, and to recover your losses, you need a 150% return, which is unlikely. If you increase your bet to 250 yuan, it’s very likely that you’ll go bankrupt after four games. In any case, this simple game cannot be profitable without money management. The risks are too high and there is no balance between risk and opportunity.
It is believed that 70% of traders lose money, 10% break even, and only 20% make money. Therefore, by reducing the amount you invest to a very small number, you can move from the 70% losers to the 10% who at least break even. If you are eliminated, you can no longer continue trading. You must ensure that you can keep trading. However, most traders get eliminated before they have a chance to succeed. With a bit of bad luck, they give up all their progress. Staying in the game is very necessary. Imagine if your method just needed a slight adjustment to turn things around, what would you do? You just need to survive and let your capital ride through the inevitable downturns. You need to make sure your time is long enough to acquire the skills and knowledge necessary to be a successful trader.
Money Management and Stop Loss
People always want to profit quickly and leave room for losses, which results in cutting profits and letting losses run. Over time, how can you achieve capital growth? Let’s remember these numbers: A 20% loss requires a 25% profit to break even, which is relatively easier; a 40% loss requires a 66.7% profit, which is much harder; and a loss of 50% or more requires a 100% profit, which is nearly impossible to recover from. In my personal experience, a 20% loss should be the maximum limit for a loss.
However, this kind of stop loss is not money management because it doesn’t tell you how much to exit, and therefore, it cannot control risk through position adjustments. Money management is an essential part of the trading system. Essentially, it is the part of the system that determines your position size. It can determine how much profit you can gain and how much risk you can take in system trades. We cannot replace the most important part with simple stop losses or money management.
Money Management and Analytical System
Going back to the earlier game, the foundation of profit is the win rate. In other words, the buy and sell points provided by your analytical system must generate profits in the long run. With an effective analytical system, money management’s role is to make the system work for you through proper position adjustment and money management. For the game above, we can assume that the analytical system has a 60% win rate, but that’s all.
If used improperly, huge losses can occur (as mentioned earlier, this explains why the same analytical system can result in drastically different investment performance). In this game, if I simply bet 10 yuan each time, my funds will eventually grow to 1200 yuan. Of course, there are better betting strategies. Comparing the various betting methods clearly shows that different strategies lead to completely different results. Understanding the importance of money management is one of the biggest secrets in trading.
Section 2: Money Management Strategies
There are countless strategies for money management. Professional gamblers have long claimed that there are two basic strategies: the equivalent martingale strategy and the reverse equivalent martingale strategy. In a losing trade, the equivalent martingale strategy increases the bet size when capital decreases; on the other hand, the reverse equivalent martingale increases capital after a winning trade or when capital increases.
If your risk keeps increasing in a series of losses, eventually there will be a series of very large losses that could lead to bankruptcy because the equivalent martingale strategy carries massive risks. The reverse equivalent martingale involves taking greater risks after a series of wins. In investing, smart investors increase their investments within a certain limit when they are making profits. Just as there are various ways to enter the market, there are various money management strategies. Below are some reverse equivalent martingale money management models:
Fixed amount per unit: This model allows you to buy one position with a fixed amount of money. It treats all investments equally and always allows you to hold one position.
Equal unit model: This model gives equal weight to all investments in the portfolio based on their fundamental value.
Risk percentage model: This model’s money adjustment rule is based on risk as a percentage of capital. It gives all trades the same level of risk and allows a stable portfolio growth. This model is best suited for long-term trend followers.
Volatility percentage model: This model provides a reasonable balance between risk and opportunity. It is suitable for trades with tight stop losses.
