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Old 01-10-2008, 12:33 PM   #1 (permalink)
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Money Management: How to Determine an Initial Stop Level


In our last lesson we looked at the difficulty of overcoming a loss in the market to further emphasize the importance of protecting your trading capital as a critical component of any successful trading strategy. In today’s lesson we are going to start to look at the first and one of the best ways of protecting one’s trading capital, setting your initial stop loss.

As we learned about in our lesson on the effects of trading losses, 50% or more of the trades made by many successful trading strategies are losers. These trading strategies and traders are successful not because they are highly accurate on a trade by trade basis, but because when they are wrong they cut their losses quickly and when they are right they let their profits run. While the trading strategy that you eventually end up trading for yourself may have a higher success rate than what I mention above, any strategy is going to have loosing trades, so the first key to staying in the game is to have a plan for managing those losses so they do not get out of control and wipe out your chances for success.

With this in mind, what most traders will start with when designing a plan for setting their initial stop loss is the amount they can afford to loose on a per trade basis without having a detrimental affect on their account. While this varies from trader to trader and from strategy to strategy, as Dr. Alexander Elder mentions in his book Trading for a Living, many studies have shown that trading strategies and traders who risk more than 2% of their overall trading capital on any one trade are rarely successful over the long term. From what I have seen most traders risk way more than this on an individual trade basis, another large contributor to the high failure rate among traders.

Traders who set their per trade risk level at 2% of their trading capital or less, not only put themselves in a situation where a fairly lengthy string of losses will not knock them out of the game, but also put themselves in a situation where any one trade is not going to make or break their account. This is important not only from a money management standpoint but also from a trading psychology standpoint in that they are not attached to any one trade and are therefore more likely to stick to their strategy.

In order to have a true understanding of what this number should be for a specific strategy you will need to know what the expected accuracy rate is for the strategy, something which will cover in later lessons. For now however it is sufficient to simply understand that you need to have a feel for how much you plan to risk on a per trade basis as a first step in designing a successful money management strategy, and that you should be very wary of any strategy which risks more than 2% of your trading capital on any one trade.

Now that we understand that determining how much to risk per trade is the first step in any successful money management strategy, we can move on to other methods of setting your initial stop which fit within the limit set by the amount a trader is willing to risk on a per trade basis.

As always if you have any questions or comments please leave them in the comments section below so we can all learn to trade together, and good luck with your trading!

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Old 06-24-2008, 04:09 AM   #2 (permalink)
 
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Hello Dave,

Thanks again for all your videos! This section is definitely the missing link in my trading strategy that I have been looking for.

Whenever I hear 2%, it sounds so little. But when you actually do the calculations, it's quite a lot.

For example an account of $20,000. 2% would equal $400.

That's $400 at risk for each trade, that's quite a lot in my opinion.

I totally agree with the 2% rule.

Thanks again.

Sincerely,
Bill

PS> Your previous video is a repeat of the one before.
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Old 06-24-2008, 07:07 AM   #3 (permalink)
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Hi Bill,

Yes I would say you are not alone there when you say that at first 2% sounded too small as I was in that boat too. What kind of made it all click for me is when I tied this into trading psychology and the ability to last over the long term. At 2% risk it is a lot easier to be emotionally detached from each trade which helps me make better decisions as I know that I can have a long string of losses before I am in danger of being knocked out of the game.

Thanks for the heads up on the other video, you can view the correct video there now.

Best Regards,
Dave
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Old 08-07-2008, 01:47 PM   #4 (permalink)
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Hey Daniel,

Glad to hear from you and very well put. I am glad to see we have a growing community here of traders who understand the importance of money management, as in my opinion this raises the quality of the community substantially.

Best Regards,
Dave
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Disclaimer: Trading is risky and can result in substantial financial loss. As always my posts are simply one traders opinion and should not be taken as trading advice. I am not a financial adviser so everyone please do their own analysis and take responsibility for their own trades.
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Old 12-14-2008, 04:51 PM   #5 (permalink)
 
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HI Daniel...

Im a newbie and found your post very interesting... Id like to know how you calculate your risk for a $1000 trade. In my case, I have to pay a minimum comission of $15 for every movement (30 to buy and sell). So, even if I buy for $1000 and wanted to sell at a loss, I would have a loss of 30 minimum...

Good luck trading...

Quote:
Originally Posted by daniel_asimov View Post
Hello David...

Money management for sure is the most important pillar of trading.
And unfortunately the most neglected.

Bill..
You where commenting an example for the 2% rule .


In my case... from the total amount of my account I calculate the 2% and break it down from there.
Example:

Account Value: 20,000
2% Risk: 400

Which I break down into pieces like this.
for every 10,000
risk: 200

and going deeper...
For every 1,000
risk: 20

It sounds very little when taking in consideration spread cost or/and fees.

What I use this for is to discipline myself on trading proportionally in
accordance to the size of the trade vs the size of the total account.

Won't make sense to risk 200 on a 1000 trade.. Even if 200 is 2% of the overall account, it's a BIG 20% in this single trade.

I might be wrong on these one... But it works for me so far.

Good trading.
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Old 02-14-2009, 08:49 AM   #6 (permalink)
 
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Need your advice


Hi dave,
First of all let me thank you for sharing your knowldge with us by posting your wonderful videos. you have been very helpful to me and to many others.

I am a forex trader who opened a 1500$ account and I am setting my stops at an average of 100pip and I feel it should not be less that that as I trade on hourly chart. I enter trades with one lot(Lot=50$) that means that i am risking almost 7%
(100$/1500$*100=almost 7%) of my account each trade. When i saw your videos in money managment you said that we should not exeed 2% but I enter trades with the minimum amount of lots(1 lot).In order to set 100pip with 2% risk that mean I should have a 5000$ account to beging trading.

Should I fund my account more up to 5000$ or I continue to trade normally, knowing that 1 lot(50$) =3% of my current account.

thanks again for reading my message
Best ragards
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Old 02-16-2009, 09:24 AM   #7 (permalink)
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Hi Mostafa,

Glad to hear from you and thank you for the compliment I am glad you like the videos.

I am not a financial advisor so I can't give individualized trading advice, but in general I think most traders in this situation would reduce their position size by switching to a micro account. If you are trading with FXCM you can easily transfer your account to a micro account which trades a contract size of 1000 of the base currency instead of 10,000 of the base currency.

Hope that helps.

Best Regards,
Dave
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Old 07-14-2009, 09:39 AM   #8 (permalink)
 
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Hello Dave,

first of all I want to thank you for all the great work you have done with this community.

There is something that I can't fit into money management. Let's say my account size is 10000$ and I want to stick to the rule not to risk more than 2% per trade.
So I buy 1000 shares at 2$ and set a stop at 1.8$. After entering this trade I have 8000$ left in the account. Now I also believe in diversification, you can diversify with cash, but I think depending on market conditions 80% cash is far too much.
From this point of view is it a viable strategy to enter more trades with 2% risk, so that my total account risk becomes more, and if so, how high should the total account risk eventually be?
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Old 07-14-2009, 10:11 AM   #9 (permalink)
 
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Quote:
Originally Posted by freiheit View Post
Hello Dave,

first of all I want to thank you for all the great work you have done with this community.

There is something that I can't fit into money management. Let's say my account size is 10000$ and I want to stick to the rule not to risk more than 2% per trade.
So I buy 1000 shares at 2$ and set a stop at 1.8$. After entering this trade I have 8000$ left in the account. Now I also believe in diversification, you can diversify with cash, but I think depending on market conditions 80% cash is far too much.
From this point of view is it a viable strategy to enter more trades with 2% risk, so that my total account risk becomes more, and if so, how high should the total account risk eventually be?
Generally speaking, the outcomes of individual trades do not depend on each other (in fact some dependency exists but because it is extremely difficult to determine what the exact relations are, it is mathematically wise to treat all trades as non-dependent). In statistics, this is called sampling without replacing. Therefore, there's no problem with running multiple trading positions simultaneously -- as long as you can manage them. However, it is not necessarily recommended for a beginner.

There is, however, the six-percent rule by which many traders abide, meaning that they stop trading for the rest of the month if they lose more than 6 percent of their equity during that month.

I don't know if I missed some element of your question, but if you're worried about 80 percent of your account equity lying around, there's nothing keeping you from placing all your equity on the trade -- as long as you're risking two percent at the most. How much money you can place on the trade is basically determined by how tight your stop loss order is. So, to buy 5000 shares at 2 dollars a piece, your stop loss price would have to be at 1.96 in order for it to be ok to enter the trade.

Proper position sizing can be quite tricky, but I wouldn't worry too much if you don't get it right away... It will become clear by time.

Diversification doesn't apply quite the same way to trading as it does to investing. It can reduce drawdowns but not nearly as much as people tend to think.

Cheers,

Demolition Man
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Old 07-14-2009, 10:38 AM   #10 (permalink)
 
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Thanks for your quick answer, it's very helpful to me.
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