Trade Management Rules vs. Money Management Rules

You can read the episode transcript below or watch the video that follows.
If you have any questions, please reach out to us. We look forward to being a continued part of your trading education!

Now this topic we're going to talk about today is a topic that you'll rarely see discussed and this is actually going to be a great gift to you that I talked about this. This is something I usually reserved for discussion in my private groups with my high end traders, but today, I'm going to share this with you because I think you're going to find this to be really insightful. This discussion is often a game changer for many, many traders who have never thought about their trading in this way. We talked about trade management rules versus money management rules, traders need to have both. They have trade management rules, and they need to have money management rules. In addition, they clearly need to understand which category the rules fall in. See traders get themselves in trouble because they don't even know these two categories exist. They just have, in their mind, trade management rules and they kind of force all their rules into one bucket. They're not really aware of the idea of having money management rules, they have the idea of like "I have a position size that you put on in the beginning", but that's really about it. If we can understand that we need to have these two categories, and we can understand what rules fall into each of the categories. This has the possibility of massively impacting your trading.

Let's talk about trade management rules. This is going to be easy. This is what you already know. Trade management rules are the rules about when you enter a trade and when you exit a trade. They tell you when your trade sets up for entry, and they tell you when your trade is over for exit. These rules tell you when you're wrong when your trade’s not going to work and typically, these rules are what we call negative reversion rules. This means that you typically are buying high and selling low. You'll be entering on a stop, maybe you're buying a breakout and entering on a breakout and then more often than not, you're using some type of trailing stop to exit the position. Remember, anytime we have a negative reversion entry, we're buying at the offer and it might be the high of the day or the highest session and we're selling on the bid and selling at the low of the day or the low this session. Otherwise you wouldn't be stopped in or stopped out. We're giving up edge in both these scenarios. When we look at the components of trade management rules, we have entry, we have our initial stop or risk placement. We have our trailing stop if you use one and then we have ways of exiting on strength we talk a lot about managing our trades from above and from below so for long managing from below is our initial stop, managing from above is peeling or exiting the trade on loss of momentum, peeling exiting the trade on extremes where the market's overbought or oversold. These are the components for Trade Manager rules and this is going to sound familiar. 

Now we move on to money management rules. When we talk about money management rules, these are all about your objectives. As you know, I spent a lot of time studying with Dr. Van Tharp. Van was a close friend of mine and Van was a pioneer in the field of position sizing. He worked with a lot of hedge funds, and really top traders early in his career and he saw this was something that top traders did. His work in position sizing was really, really good, but it was often misunderstood. Now, if you ever had a conversation with Van, the first thing he would always say to you is you need to be clear about what are your objectives. Most traders have no idea what their objectives are. They just say "Well, I want to make money. What's the problem? That's my objective." That's not enough. The clearer we are about our objectives, the more we can then create money management strategies to meet them. This is what he would say. We've got to get clear about what our objectives are. 

Now for our discussion today, to keep this really simple, we can think of this in two camps. The first camp is "I want to smooth my equity curve. I don't want big draw downs. I don't want to make a bunch of lose a bunch make a bunch lose a bunch." If you want to avoid drawdowns, then you need to smooth your equity curve. You can have money management rules that help you smooth your equity curve. Now, the flipside to smoothing your equity curve is to go for making as much as you can. If you say "Well, I want to make as much as I can and I don't want to draw down on the surface", you're setting yourself up for tremendous conflict and not being able to do what you want to do. The reality is that you're not going to be able to make the maximum amount unless you're willing to take risk. You cannot smooth your curve and make the maximum amount you'll choose. What you'll find is if you smooth your curve, you'll make money consistently, but you'll see that you could have actually made more, that you have left money on the table. You want to go and make the maximum amount you can, well, you're going to have to have volatility in your equity curve. In fact, the place where you make the maximum amount of money is usually right next to going bankrupt. That's gonna make most people incredibly uncomfortable. What do you want? Do you want to avoid drawdowns and make money consistently? Or do you want to make a lot of money? This is where we choose.

Most traders I work with fall in the camp of wanting to smoother equity curves. Let's talk about that. There's key questions that we need to answer for objectives. One, what is the amount you're willing to draw down? Whatever your answer is. So if you say, "Well, I'm willing to lose 10% of my account or I'm willing to lose 20%." Let's just say save 20%. "I have a $200,000 account, and I'm willing to lose 20%, I'm willing to lose 40,000 in 200,000." Okay, great. What I find is whatever number people tell me, usually we cut it in half, because if somebody says to me, "I could lose 40,000 and I'd be okay." I know they're down 20,000, they're probably gonna freak out. They're going to be really emotional, really scared, really fearful. We'll cut in half and we'll say if you say you can lose 40,000, then we'll say great, we'll go with 20. Then here's the other key question, what is the point that you're uncomfortable with your open risk? This is the biggest thing I see with traders that don't have some major psychological flaw. Most traders I work with, they have no issue containing losses, where they really get in trouble is when they have big open profits. They get very fearful that they're gonna get these open profits back. As a result, what they do is they tighten their stop, they figure well, if I tied my stop, I can't get my profits back, but this is the key of what I'm talking about in this lesson, which is that they are using a trade management rule, ie a trailing stop, to address a money management issue. I'm scared of giving back my profits. This gets them into tremendous trouble, because now what they're doing is they are virtually strangling the trade, assuring that they're going to get stopped out. They get stopped out and then they watch the trade take off without them. Tightening your stop to protect your equity is one of the worst things you can possibly do. One of the worst. In our ironically, 95% of all traders and all trading educators tell you to do this very thing that just fucks up your trades. Don't do it. That's why this lesson is so important. We do not tighten our stops, we don't manage our equity curve with trade management rules, it just causes problems.

Instead, what we should be doing is identifying in advance what is the amount of open risk I'm going to feel uncomfortable with. If I bet $2,500 on something and I get up $10,000, I know I'm going to start to have anxiety about giving the 10 Grand back. Great, let's just be honest and acknowledge that and at the point that we know we're going to feel uncomfortable at $10,000 or four R, then we're going to start to scale out. We're not going to run a trailing stop, we're just going to start selling out some. Let's talk about some ideas for doing this. One, we could scale out and open risk to stop. We know our open risk level and then we would set what we call a step down interval. If I get up $10,000, that's my max open risk level, I'm going to reduce my risk by a certain amount. In this case, we might say I'm going to reduce it by 25%. I'm going to sell out 25% of the position and I will keep the rest on. Let's say that the max risk in this case, I use 10,000, let's make this simple. Let's say that we are batting $1,000 on a trade and $100,000 account and the trade is now up 2000 Our max open risk is $3,000 If we sell 25% of position we'll have reduced our open risk from 3% to 2.25%. In the case that the market keeps going the open Riscal grow again and every time it gets to 3% it will clip it, it gets to 3% will clip it. This will have a selling higher and higher and higher and the great thing about money management rules is we tend to sell high and buy low, just by the nature of the rules. Then when the market eventually rolls over, you'll have been selling on the way up and capturing gains. We have to decide what is the step down interval. In this case, we're using reducing by 25% and we have to decide what is the time interval, when are we going to do this, or we can do it the moment it hits 3%? Are we can do at the end of the day at 3%, end of the week? You can choose the time interval. You have a max exposure to the account and when the level is reached, and a time intervals reach, you'll reduce the position.

Another way you can do this is to scale out of volatility risk. You measure the volatility of the market and you multiply your position size by the ATR risk. One of the things we're going to see is that in a dynamic trend, ATRs can grow, the volatility takes off. What this means is that your risk in a position is growing because the volatility is getting bigger. What we do is we have a maximum amount of volatility risk at any given point. Let's just say that we measure our risk in terms of volatility, and we have a size that 1%. Well, what this means is that volatility grows, our volatility risk in the account is going to grow and we're going to have to sell some to get it back down to 1%. Inputs to consider for volatility stop would be what is the overall level of open volatility risk? How much are we going to step down? When are we going to do it? 

I gave you some great things to think about. I've had students this has completely changed the way they trade, completely. I encourage you to take a look at it and consider it and if you are interested in learning more about it, come find us at tradingmatrix.com. We talk about this in our trading courses. This is just one of the many topics that we go through. Otherwise, I'll see you next week with another Trader Tip Tuesday where we go through additional tips like today to help you get your performance to an elite level. Have an amazing week. I'll see you next Tuesday. Bye