If we conduct an attribution analysis on a beautiful net worth curve, then a stable trading strategy may only account for 50% of the factors, and the other half of success depends on your capital management strategy. Almost all successful traders believe that in actual combat, the importance of capital management cannot be overemphasized.
But unfortunately, the answers given by everyone are very different. This is because different capital sizes require completely different capital management strategies. The strategies followed by an account that grows from 500 US dollars to 5,000 US dollars are completely different from those of an account that grows from 100,000 US dollars to 150,000 US dollars.
In today’s sharing, I will extract some generally applicable capital management rules from my experience in interviewing traders or fund managers.
Maximum Loss per Single Trade
Many people may have heard of the 2% rule, that is, the amount of funds used each time should not exceed 2% of one’s overall position. But how should this 2% be calculated? In my personal opinion, this 2% should refer to the stop-loss amount of this single trade. For example:
You have a position of 10,000 US dollars. 2% is 200 US dollars. Plan to go long on gold at 2655 and set a stop-loss at 2650. The stop-loss for one standard lot is 500 US dollars. Then we can reverse-calculate the lot size through the stop-loss amount and stop-loss point. For example, 200 US dollars ÷ 500 US dollars = 0.4 lots.
Here, the amount of funds is fixed in advance, and the stop-loss point is also unchangeable as it is formulated according to our trading plan. So what we can change is the lot size to control risks through lot size.
But capital management is not rigid. We can also flexibly adjust the position according to the market trend in trading.
Building a Safety Cushion
Many traders may think that a beautiful net worth curve is the result of trading. But in fact, net worth curve management itself is also an art. I have interviewed many public fund managers. When it comes to net worth curve management, they will more or less mention a word: safety cushion.
The safety cushion is closely related to the suggestion of “preserving principal” in Livermore’s five major rules of capital management.
How can we preserve principal? Some investors may say that not trading naturally can preserve principal. But gains and losses come from the same source. If you don’t take the risk of losses, naturally you won’t earn any profit. So how can we pursue profit while preserving principal?
We should understand that preserving principal does not mean accepting no principal loss at all. Instead, we need to clearly define in advance how much loss can be accepted, such as 10% of an account.
In other words, start with a conservative strategy or light position operation, such as 0.05 lots or 0.1 lots each time at the beginning. After accumulating 10% profit, gradually increase the position with this 10% profit. At this time, we can increase the position to 0.1 or 0.15 lots.
Conversely, if there is a loss after having 20% profit and the profit is reduced to 10%, naturally the position should also be reduced at this time, returning from 0.2 lots to 0.1 lots.
Flexible Return
After establishing a safety cushion, we can consider pursuing the second stage: the stage of flexible returns.
As mentioned earlier, if we strictly follow the 2% principle, it will cause a great waste of funds. Therefore, when we establish a safety cushion, we can improve the utilization efficiency of funds. In this process, the principal part still adheres to the 2% principle. But for the safety cushion part, it can be increased to 5% or 10%.
For example, we have 10,000 US dollars in funds. When the funds grow to 11,000 US dollars. How should we set the maximum lot size? At this time, the principal part still follows the 2% principle. If we still go long at 2655 and set a stop-loss at 2650, the lot size deduced from 2% of the principal part is 0.4 lots.
But for the safety cushion part, we can increase the utilization rate. For example, to 10%, that is, 100 US dollars. The deduced lot size is 100 ÷ 500 = 0.2 lots. At this time, adding the 0.4 lots of the principal part, we can operate 0.6 lots.
Take Profits
If our system is stable enough and we are fortunate to accumulate more profits, then we can consider entering the third stage: taking away profits.
Livermore believes that only when the earned profit enters one’s own deposit account can it be considered real money-making. Therefore, the last of his five principles of capital management is to regularly withdraw 50% of the profits.
Note that it is 50% of the profits here, not 50% of all the account funds.
Suppose our $10,000 account gradually accumulates to $15,000. At this time, we can consider taking away some of the profits. For example, for every $1,000 increase in profit, $500 of profit is taken away. After all, trading and making money itself is only a means, not an end. Taking away a part of the profits to serve a better life is the purpose.
Some investors may ask, when I have accumulated $5,000 in profits, why not take away all the principal and only use this $5,000 in profits for investment?
This relates to a topic in behavioral finance, that is, mental accounting: people’s attitudes towards principal and profits are different. When we trade with principal, we may be very cautious and carefully judge the market trend. But when we trade with profits, subconsciously we will think that this money “is not ours”, so we will trade with a risky gambler’s mentality. Once we enter this state, trading will change its taste and deviate from the original trajectory.
Reproduction Notes：InvestFancy » Capital Management: More Important than Trading Skills