Important Points that I learned from Come Into My Trading Room by Alexander Elder - Part 4

IV - Important Points that I learned from the book – Come Into My Trading Room by Alexander Elder


MONEY MANAGEMENT FORMULAS

1)      Successful trading is based on 3 M’s: Mind, Method, and Money. Mind is trading psychology, Method is market analysis, and Money refers to risk management. This last M is your ultimate key to success.

2)      Money management is the craft of managing your trading capital. Some call it an art, others a science, but really it is a combination of both, with science predominating. The goal of money management is to accumulate equity by reducing losses on losing trades and maximizing gains on winning trades.

3)      A good trading system gives you an edge in the market. To use a technical term, it provides a positive expectation over a long series of trials. A good system ensures that winning is more likely than losing over a long series of trades. If your system can do that, you need money management, but if you have no positive expectation, no amount of money management will save you from losing.

4)      Trading is a numbers game. If you cannot count, you cannot trade.

5)      A businessman’s risk exposes you to normal equity fluctuation, but a loss threatens your prosperity and survival. You must draw a line between them and never cross it. Drawing that line is a key task of money management.

6)      What is the definition of a loss? - A loss is a violation of the percentage rules—the 2% and the 6% Rules.

7)      Futures—OK to Trade Spreadsheet - To find out which futures markets you may or may not trade, measure your equity against the recent level of market noise. Begin by calculating 2% of your account. Measure the level of noise with the SafeZone indicator, calculate its 22-day EMA, and translate that into dollars. Do not trade any market whose average noise level is more than 1% of your equity. If you follow this rule, you’ll trade relatively sedate markets where you can safely place your stops.

8)      Whenever the value of your account dips 6% below its closing value at the end of last month, stop trading for the rest of this month.

9)      The 2% Rule will save you from a disastrous loss, while the 6% Rule will save you from a series of losses. The 6% Rule forces you to do something most people cannot do on their own—stop losing streaks.

10)  If you buy a stock, it rises, and you move the stop above breakeven, then you may buy more of the same stock, as long as the risk on the new position is no more than 2% of your account equity and your total account risk is less than 6%.



POSITION SIZING

1)      When the level of risk goes up, our ability to perform goes down.

2)      A professional trader needs strong money management skills. All successful traders survive and prosper thanks to their discipline. The 2% Rule will keep you safe from the sharks, the 6% Rule from the piranhas. Then, if you have a half-way decent trading system, you’ll be far ahead of the game.


MONEY MANAGEMENT STEPS
 
1)  Once you’ve learned to trade—find trades, enter, set stops and profit targets, and exit—you can start increasing your trading size to the point where your account starts generating a meaningful income.

2)  These are the steps of proper money management:
       a)Measure your account value on the first of the month—the total of cash, cash equivalents, and open positions.
      b)Calculate 2% of your equity. This is the maximum you may risk on any given trade.
      c)Calculate 6% of your equity. This is the maximum you are permitted to lose in any given month, after which you must close out all trades and stop trading for the rest of that month.
      d)For every trade, decide on your entry point and a stop; express your risk per share or per contract in dollars.
      e)Divide 2% of your equity by your risk per share to find how many shares or contracts you may trade. To get a round number, round it down.
      f)Calculate your risk on all open positions by multiplying the distance from the entry point to the current stop by the number of shares or contracts. If the total risk is 4% of your account or less, you may add another position, since you’ll be adding 2% with your current trade, bringing the total to 6%. Remember, you do not have to risk 2% per trade; you may risk less if you like.
     g)Put on a trade only after meeting all of the above conditions.

3)  On the first of the month, if you have no open positions, the 2% and 6% levels are easy to calculate. If you approach the first of the month with some open positions, calculate your account equity—the value of all open trades at the latest market price plus all cash or money market funds.

4)  Remember, both your trading system and your money management must be good in order to win in the markets.