A trader\'s money management system

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56 A TRADER’S MONEY MANAGEMENT SYSTEM

control. A good rule of thumb is to never risk more than 2 percent

of the capital in your trading account on any one trade. (Advanced

traders, see important note following this list.)


Market risk.Theinherentrisk of being in the market is called market

risk and we have absolutely no control over this type of risk. It includes

the entire gamut of risk possible when in the markets. Market risk may

cause your carefully calculatedtrade riskto be much larger than antic-

ipated. Market risk can be far greater thantrade risk. For this reason

it is best that you never trade with more than 10 percent of your net

worth. This type of risk encompasses catastrophic world events and

market crashes that create complete paralysis in the markets. Events

causing marketgapsin price against your trade are also considered to

be market risk.


Margin risk. This involves risk where you can lose more than the dol-

lar amount in your margined trading account. Because you are lever-

aged, you thenowethe brokerage firm money if the trade goes against

you.


Liquidity risk. If there are no buyers when you want to sell, you will

experience the inconvenience of liquidity risk. In addition to the incon-

venience, this type of risk can be costly when the price is going straight

down to zero and you are not able to get out, much like the experience

of Enron shareholders in 2001. Liquidity risk can be caused by or ag-

gravated by amarket riskevent.


Overnight risk. For day traders, overnight risk presents a concern

in that what can happen overnight, when the markets are closed, can

dramatically impact the value of their position. There is the potential to

have agap openat the opening bell where the price is miles away from

where it closed the day before. (See the sidebar “Rules of Engagement”

later in this chapter for determining how to hold trades overnight.) This

gap possibility can negatively impact your account value.


Volatility risk. A bumpy market may tend to stop you out of trades

repeatedly, creating significant drawdown. Volatility risk occurs when

your stop-loss exits are not in alignment with the market and are not

able to breathe with current price fluctuations.

IMPORTANT NOTE: For some advanced traders, it is beneficial to

risk more than 2 percent of their trading account. The amount these

traders risk must be carefully calculated depending on their proven

historical performance statistics. See Chapter 9 for the formulas to

determine if your payoff ratio and win ratio performance warrant a

higher risk than 2 percent.