The Good, the Bad and the Ugly
Money Management, Risk and Trading Logic
"Survival" is possibly the most important aspect in trading. Money management and risk management may sound like boring subjects, but read on to see how exciting they can be once you learn the concrete reasons and logic behind their use. You may never trade the same way again!
Letís talk more about the most important subjects in commodity futures and option trading; money management, probability and risk.
We need three things to be successful in commodity trading. With all three working well, we are like a three-legged tripod that is standing firm. Take one away and the whole commodity trading program falls apart. First, we need good market analysis to tell us when and where to buy and sell. Next, we need the right psychological frame of mind to effectively carry out the plan with minimum errors. And last, we need prudent money management techniques to stay in the game.
We can have the best buy and sell points in the world, but if we put all our money on each commodity trade, we will soon be wiped out. We can also have the best money management, but if our timing is bad then we will fail. We can even have great buy & sell points AND good money management, but if we aren't following our rules then we will fail. All three of these things must be in sync as they are ALL equally important. The same applies to stock trading.
Letís focus on money management. I have watched many professionals abuse this key aspect of trading over the years. Many commodity futures traders spend a lifetime on market analysis but little time on money and risk management. I think this is because many futures traders simply do not understand the survival mathematics of the game. As with many things in trading, they quickly become transparent once they are explained:
Letís take a few examples. Assume that we are trading at 50% accuracy ñ that is, half of our trades are profitable and half are losers. Fifty percent accuracy is superstar status for most OTM options buyers, a great average for long term traders, reasonable for day traders and very poor for OTM options sellers.
As you can see, the percentage of accuracy (win/loss ratio) can be anywhere from 10% to 90% for a profitable commodity trader; it all depends on the trading method used and the person's trading skills. Of these two, the biggest effect on the win/loss ratio is the TYPE of trading method used.
To analyze your own trading accuracy, begin by discovering the ballpark percentage for your general trading method. This is a rough figure based on a simple back-testing of your performance record. After that is complete, determine your real-world accuracy over a long period of time through actual commodity trading. To break even at 50% win/loss accuracy, we must have a 1:1 profit to loss ratio.
For example, our average loss must be $500 and the average gain must be $500 when trading at 50% accuracy to break even. Of course, this does not account for commissions, human execution errors and slippage. When these factors are added to the mix, the accuracy (win/loss ratio) would have to be significantly BETTER than 50% just to break even.
More examples: If we are completing three out of four commodity trades successfully, (75% accuracy) then we can break even with $750 losers and $250 gains. And if we are trading with a 25% accuracy, then we must see $750 gains and $250 losses to break- even. (not including expenses) See the point?
Continued in "The Good, the Bad and the Ugly - Part Two"...
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