MONEY MANAGEMENT FOR ENTRY AND EXIT STRATEGIES

Amateur traders often disregard the importance of money management in their entry or
exit strategies, with either too much exposure per trade, taking profits too early or making
the grave mistake of refusing to cut losses. These issues are common and it is best to
recognize them at an early stage.

The determining factor of success lies not in the size of the trader’s account but in his beliefs
about what successful trading consists of and what he needs to do to achieve it. Let us
deliberate on certain money management strategies commonly used by experienced
traders that have helped lock their profits in and at the same time, minimize their risks and
losses.

ENTRY STRATEGIES

1) Eliminating Irrational/ Unrealistic Mindsets

The problem that most traders with small accounts face is their sense of urgency to make
money and this “need” or desperation impedes their decision making process. Acquiring the
right mindset for trading is crucial for growing your account and it should be the priority
before entering your first trade. One should never let this desperation to make money be
his main emphasis; rather, more attention should be placed on analyzing the markets and
trading it with patience.

The dangers of trading with a feeling of “need” results in moving concentration away from
risk management and mastering profitable trading strategies. A great start to effective
money management will be to eliminate such mindsets and aim towards capital
preservation and developing consistency in your trading.

One must understand that it is unrealistic to assume a “one hit wonder” mentality; in fact, it
is disastrous to the fundamentals of your trading strategies. Once too much focus is given to
making huge sums of money in an extremely short time, there is a natural tendency to take
up risks that the account size is not able to withstand, especially if there are sequential
losses.

To make consistent money in the markets, traders must first weed out these irrational
concepts and realize that successful trading is built around an attainable trading plan with
strategies that have been refined over time. There must be strict discipline to stick to one’s
plan and not stray from the primary objectives or lose emotional control.

2) Position Sizing

If one sees himself asking, “how much money do I need to earn $X?” he has missed the
point of successful trading, because it is often not as simple. One of the best money
management methods used by professionals is to always risk a fixed percentage of your
equity (being prepared to lose e g. 2.5%) per position. This is in contrast to the fixed dollar
bet, e g $1000 per trade, which grows the account arithmetically.

By using this method, one gradually increases the size of his trade while he is winning
(account is increasing in size) and decreases the size when he is losing. This is known as
profit compounding which increases the size of bets during a winning streak, allowing for
geometric growth of the trader’s account, which occurs when profits are reinvested into
subsequent trades. Consequently, when one’s account is shrinking, it will risk less on the
next position and minimize the damage to the trader’s equity.

Take note that if you risk 25% of your account on each trade, with a 50% accuracy of wining
each time, it will take you 6 trades to double your account size, but it will also take you just
a few more losing ones to almost wipe out your account. Therefore, it is crucial to keep the
exposure of each position in check, with an acceptable 2-3% each time for beginners.

When one starts to shift away from the perception of the dollar value of profits and losses
to the percentage value of his account balance, he will inevitably have a clearer perspective
of the health of his account. This then allows him to be comfortable to trade without the
initial hesitation, even when the absolute value of the dollars risked becomes very large. He
will understand that he is not risking more than the amount dictated by the system and is
able to effectively calculate the number of lots to trade each time.

3) Using Leverage

Leverage allows traders to have positions that are larger than what their accounts allow,
while margins are the real funds that are required to be held in the account as a collateral to
cover any possible losses.

Profits and losses in the forex, commodities and derivatives markets tend to be higher than
that experienced in the equity market because of leverage. Most brokers allow a 100:1
leverage (this equates to selling USD 100 000 worth of currencies with only USD 1000),
however it might not be the wisest decision to put maximum leverage on all your trades.

Though leverage can rapidly increase your profits, it too can work against you and multiply
your losses by the same factor for every mistake you make. So should we still utilize it? The
answer is yes, but in moderation and by applying the fixed percentage position size as
discussed previously. A 1% fluctuation of currency prices could wipe out your entire capital,
depending on the amount of leverage offered by the forex broker. Using a smaller leverage
could help you prevent losing too much too fast; hence you will have to decide on a level
that is suitable for your risk appetite.
EXIT

Using Stop losses

Unless you are trading a portfolio with a hundred positions that hedge on one another, stop
losses will be relevant to you. It is an effective way to cut losses when the market reacts in
an unfavourable manner but there are several ways to ensure that it helps you stay on top
of the game and not lose too much of your capital.

Tight stop losses will cut you out of your trade too early if there are cases of retracements
and cause you to lose out on potential profits. Set the stop loss too wide and you might risk
losing a large proportion of your capital. So how much allowance should a trader give?

In most instances, traders will enter the market and then decide his stop loss limits;
however it will be prudent, if given the opportunity to decide on possible stop loss areas and
wait for a good price to enter instead. This way, traders can effectively capture profits and
minimize the probability of being stopped out of the trade, it allows him to set tighter stop
losses without too much fear of being out of the game too quickly.

Deciding on stop losses before choosing a good time to enter gives the trader time to react
and hence more allowance to manage his margins. His maximum loss should be capped at
the predetermined 2-3% of the account size as discussed in the previous section.

Risk/ Reward Ratio

We have emphasized much on managing risks in the previous sections but do not for once
believe that it does not correlate to the level of profits you plan to receive. There are times
where one can ride on a megatrend and just collect as much money as he can, but there are
also times where the markets are volatile, reversals occur more frequently and it becomes
difficult to know when to exit.

One should never enter a trade blind as it will cause him to lose the maximum and have a
tendency to only earn barely enough from profitable trades to recoup previous losses.
Therefore, one must always have a plan of the minimum profits to extract before closing the
transaction and a good guide will be to follow a fixed risk-reward ratio to decide on the risk
to take and the profits to collect.

A minimum parameter to follow is 1:2, i.e. for every one-dollar you risk; you must collect at
least 2 dollars of profits. If you do not think that you are able to make that amount on that
trade, based on the stop losses and entry point chosen, then the trade is essentially not
worth the risk. Once you have become more proficient, it is possible to increase the ratio to
a more rewarding one, for an example, 1:5.
While this may seem simplistic, many traders neglect taking this step and often find that
their losses become very large. Experienced traders on the other hand, only enter trades in
which they can attain a substantial risk-reward ratio - this requires them to wait for
considerable periods of time, but the rewards will be worth it.

Scale out your profits

If your trade had just hit your take profit limit and the trend is still going strong in your
favour, you could secure it by scaling out your profits. This simply means taking out a
portion of the profits and letting the rest of the trade continue to run. This is used in
contrast to loading or stacking, where the position is increased during a continued trend- a
less risk adverse strategy.

Scaling out your profits will ensure that whatever you have earned is safe, should the trend
reverse unexpectedly. It will give the trader some assurance to fall back on if the rest of the
margin fails in the continued trade. This is a sure way to progressively accumulate capital
though it is more conservative than increasing your stakes. Potential profits may not be as
great but it is a stable strategy where you will not risk a winning trade completely.

There is also another alternative profit scaling method where profits are moved out of your
trading account to another account for safe keeping after a certain level of capital is
reached. Given that a trader had increased his initial capital from $50000 to $80000 and
believes that he will continue to make consistent returns, he can choose to move the excess
$30000 to another account. This ensures that his profits of $30000 will never be risked
again, but some may not completely agree with this practice, as there is an opportunity cost
of more potential growth. If you are satisfied with your earnings and wish to preserve them
in the long run, this might be for you.

Money Management Will Save You

With proper money management practices, not only can you protect yourself from
destructive tendencies such as greed and pride (resulting in overtrading), you will also be
encouraged in cases of trader paralysis (when you face a losing streak).

Knowing that you are taking calculated risks, with the genuine ability to withstand knocks
from the market, you are able to trade more confidently, empowering yourself to pursue
growth. Money management skills can never be over emphasized; it forms the nexus
between the real traders and their success.

Jeremy Ang
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