Money Management is the Key to Success

MONEY MANAGEMENT IS THE KEY TO SUCCESS       

Using the Defcon trading system, we started with a trading account balance of $10,000. The overnight initial speculative margin for the CME’s e- mini-S&P, as of 2/15/2006 was $3,938 per contract. Therefore, with trading just one contract, we had committed 39 percent of our trading capital at any one time. Since our account starts with $10,000 and the system only generates less than two trades per week, we need to define when it is appropriate to increase our lot sizes. Aha! This is a novel idea and is what truly helps traders get wealthy knowing when to fold, hold, or add on.

If you look at Figure 11.5, you see a chart with an equity curve showing some pretty good gains with an occasional bump in the road. Recoverable as it is, a drawdown in profits occurs. Using system analysis can help you determine most consecutive wins and losses and what the largest loss is. Armed with that information, you can now go on to trading like a true megastar professional fund manager—or simply a downright happy camper. Why? Because that information will help you determine the next level of profits you have to build in order to increase your lot size. If you do not manage your money properly and double or quadruple your position size before doubling your account size, you could be in for a rude awakening. As you can see, the maximum drawdown experienced is -4,062.50 on 11/10/2004. If that was the day you decided to mistakenly increase your lot size, it may have potentially wiped your account out.

In Table 11.2, observe that the largest loss is $1,825. By increasing your lot size prematurely or by having an imbalance to largest loss in relationship to account balance, such as having four or more contracts on at any one time, you could wipe out not only your gains but also the majority of your account. Using statistics and mathematical formulas is what will give you an edge in the markets, from both a business stance and an emotional stance. You will be better prepared, and that should help make you a better trader.

In conclusion, one of the greatest values of data derived from back-testing a system is that it will reveal hidden intricacies about the system. Simply having a rudimentary knowledge of placing stop-loss orders is not the definition of knowing sound money management techniques. You must expand your knowledge in managing your money properly by either under- or overleveraging your trading capital. We went over a seasonal trading strategy that Stock Trader’s Almanac uses in the equity markets using the MACD indicator. I showed you how you can optimize that method by introducing the use of pivot point analysis. With the ability of back-testing a strategy, we can back-test this theory on our own; and more important, we can learn if our system or trading method has a seasonal factor that performs best or worst at certain times of the year. Then, you can also determine, based on your equity size, the number of positions you should have on while maintaining a proper risk/reward ratio.