Money management is concerned with the number of contracts you trade given your starting equity. It attempts to optimally utilize your capital to maximize your profits while preserving your account.
Losses Versus Gains
When you make a 10% loss, you need to make more than a 10% gain on your remaining capital to make up that loss and get back to your starting capital amount. This is best demonstrated using an example. If your starting capital is $10000 and you make a loss of $1000 (or 10%), your balance is down to $9000. In order to regain your starting amount of $10000, you need to make $1000 profit from a $9000 balance, i.e. a profit of 11%.
Now if you make a 50% loss, i.e. $5000 (following on from the above example), you need to make a 100% profit on your reduced balance in order to get back to your original starting capital of $10000. This demonstrates how important it is to have a money management strategy in place.
Money Management Strategies
There are many different money management strategies. You may create one that suits your particular system or use one of the more common methods described below:
Fixed Percentage of Capital
A very popular management tool is to use only a fixed percentage of your capital to trade with. In most cases, traders never commit more than 2% of their capital to any one trade.
Optimal Fixed Fraction (Optimal f)
This system was created by R. Vince. It uses the results of past trades to determine the optimal value for f (the amount of capital to be invested per trade) which yields the highest profit. This method tends to result in large drawdowns and relies on historical results to determine future capital usage.
The Kelly Criterion
Traders have adapted an equation, originally developed by J. Kelly during his research for AT&T Bell Laboratories, to calculate the percentage of your capital to commit per trade. The calculation is based on the number of winning and losing trades recorded by your trading system over a period of time.
Adding Contracts in a Trend
Another way of increasing your profit, while preserving your capital during trend trading is to add contracts as the trend develops. So, if your trading system is based on a breakout of some sort, for example the price breaks through a moving average line, the high of the previous day or a trend line, you would buy a contract. As the trend continues, you would buy more contracts at fixed intervals (say every 30 pips). By the time the trend has ended and your exit signal is invoked, you may have a number of contracts, most of which will show a profit. In this way you are not committing yourself all at once (in case of a false breakout) but you have the benefit of maximising your profit once the trend has been proven.