A trader\'s money management system

P1:a/b P2:c/d QC:e/f T1:g
intro JWBK182-McDowell April 25, 2008 16:39 Printer: Yet to come

2 INTRODUCTION

It’s been my observation for many years in working with traders and

investors all over the world that risk control tends to be the last piece

of the puzzle that most people focus on. Usually, trading entry strategies,

software, and systems win first place in the popularity contest—maybe be-

cause the belief is that the “system” will generate great fortunes.

Ultimately, a system alone won’t create great riches. In addition to the

system, traders and investors need to develop discipline and a strong finan-

cial psychology, and they must be working with true risk capital—money

they can afford to lose. Plus, they need a sound money management system

to maximize their system profits and keep them out of financial danger.

EXPECT THE UNEXPECTED

There is a world of risk out there, and managing it is a lifetime endeavor.

Every time you get in the car, you risk the possibility of having an auto-

mobile accident. When you walk in a thunderstorm, you risk getting hit by

lightning (a remote risk, but a risk nonetheless). You may face certain med-

ical risks (which vary, depending on genetic and family history) or risk of

losing your job—the list can go on and on.

Typically, in our society, we attempt to control or manage these risks

by obtaining insurance, or by using greater care in our day-to-day behavior

and choices. For example, you may very well currently have an insurance

policy that protects you from auto theft, collision, and bodily injury. You

might have medical, life, homeowners, or unemployment insurance. And if

you are really responsible, you probably exercise, eat right, and look both

ways before you cross the street.

All these precautions and procedures are designed to reduce, not elimi-

nate, the possibility of being devastated by a variety of unexpected circum-

stances. And that is just the point: These circumstances are unexpected.

Our job as traders is to make a habit of expecting and being prepared for

the unexpected.

In addition, we need to avoid a state of “trader paralysis” that can

be created by unexpected events. If we are well prepared we are better

equipped to combat the fear that trading can trigger.

SIX TYPES OF RISK TO MANAGE

IN TRADING

In the spirit of expecting the unexpected, we can always attempt to plan

for what might happen. In doing so, there are half a dozen primary types of

risk for you to consider every time you place a trade. We will cover each of