Money management is the most underrated skill in successful trading and is rarely discussed in any mainstream investment textbook. But it is a discipline that applies to all types of markets, all the time. In today’s speculative environment, many retail investors ignore money management at their peril.
According to Dr. Van Tharp’s Money Management Model most investors focus on “what to buy.” Yet Tharp argued that what you buy accounts for just 10% of your trading success. Far more important is your decision when to exit a trade (30%). The most critical factor in trading is how much you invest in an idea (money management), or “position sizing.” According to Tharp, position sizing accounts for 60% of your trading success.
Schwager’s interviews with the world’s top traders in Market Wizards confirmed this. When Schwager asked traders what the most crucial thing in their trading was, they always said the same thing: “bet size.” And this understanding made them surprisingly conservative. As market wizard Larry Hite observed: “Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade. Keeping your risk small and constant is absolutely critical.”
Here are some of Dr. Van Tharp’s rules:
1. Always set your exit price before you enter a trade.
2. Use that exit price to calculate the maximum you are willing to lose on that trade and size your position accordingly.
3. Never risk more than 1% on any one trade.
Successful trading is less about being right than making sure that you stay in the game long enough to win.
Sven Franssen