Sunday, January 17, 2016

Money Management in Trading: Gaining the Upper Hand by Playing Your Hand Correctly

Yesterday's post on how to renew yourself after a challenging market week is an important one.  It's easy to become so caught up in short-term market action that we fail to pace ourselves through the market year.  Many times we make poor decisions, not because we lack effort or discipline, but simply because we've depleted our resources and no longer have the concentration and energy level to properly identify and pursue opportunity.

A measure of a trader's wisdom and experience is the amount of thought they put into money management.  I've emphasized in the past that you should never lose so much in one trade that you cannot be profitable on the day.  Similarly, you should not lose so much in a day or week that you can't be profitable on the week or month.  You will always lose money, you will always have losing trades, you will always have drawdowns, and you will always have periods in which you're out of sync with markets.  Good money management allows you to stay in the game--emotionally and financially--during those periods of downturn.

There's another facet of good money management, however, and that's maximizing opportunity when it is present.  My general experience is that losing trades usually become losers early in their life.  If I'm not stopped out within minutes of my entry, the odds are good that I have a winning trade.  At some point, buyers can't push the market higher or sellers cannot push us to fresh lows and I recognize that my trade is working out.  That recognition is important--and I rarely see it discussed as a topic in trading psychology.  It's not the issue of being right or wrong, and it's not the issue of being confident or fearful.  Rather, it's the insight that comes from a kind of Bayesian reasoning in which we continuously update the odds of our trade working out.  At some point, we're not just right in the trade, but we recognize that the odds have tilted greatly in favor of this being a profitable trade.

That experience of not just being right but recognizing that we're most likely right can be a powerful cue to add to the trade.  If our Bayesian updating is accurate, that added piece should have a high hit rate, which more than makes up for the fact that the add is closer to the target than the initial entry.  Adding to the trade when the odds of success have risen is a way of ensuring that you'll be smallest when you're wrong and largest when you're right.  A good add is as good as a good fresh trade.

Sound money management places us in control of our finances.  We cannot control markets, but we can control the size of our betting and we can control our bet sizing as we draw cards and our hand unfolds.  A good trader trades with the odds.  The great trader recognizes how the odds shift during the life of the trade and bets accordingly.

Further Reading:  The Importance of Playing the Right Game