To trade successfully a trader needs an adequate understanding of three principles.
Forecasting ranges from full price/time/extent prediction through to merely being bullish or bearish. It is dealt with using fundamental analysis primarily, though Elliott Wave, Fibonacci and Gann methods are also said to provide useful technical insights. Forecasting says what to trade.
Timing is almost entirely based on technical analysis, indicating specific entry and exit points. Timing specifies when to trade.
The third principle is money management, the allocation of funds. A good trader can make money in the long run, money management is intended to help the trader play to the odds and therefore have a greater chance of preserving capital until the long run is reached. Money management says how much to trade.
Money management is about many things, the portfolio makeup, diversification, how much capital to invest in each market, the use of stops, reward-to-risk ratios, what to do after periods of success or adversity and how aggressively to trade.
Portfolio management can get very complicated, using advanced statistical techniques such as market profile, (click here for a more comprehensive page on market profile), and using the risk management techniques of portfolio theory. Various advanced books on trading deal with these (and bits appear elsewhere in this FAQ) but here are a few basic guidelines frequently used by futures traders, either as-is or slightly modified.
Never invest more than 50% of trading capital in speculative trades, the balance can be held in T-bills. The other half is kept in reserve for margin calls, as a buffer against disaster.
Total commitment in any one market should be limited to only 10 to 15% of total equity. In a $100,000 trading account therefore a maximum of $15,000 should be placed as a margin deposit with the broker.
The total amount risked in any one market should be limited to 5% of total equity. This 5% represents the maximum tolerable loss per trade, and stops should be set accordingly.
Total margin in any market group should be limited to 20-25% of total equity. Various precious metals often trend together, frustrating the principle of diversification.
Diversification is important but should not be overdone. It is too easy to take positions in an excessive number of trades and thus attention to each trade is reduced, increasing the chance of taking losses. The more negative correlation in the portfolio the more diversification is achieved. Many foreign currencies trend together against the $US so a portfolio of currencies is not diversified.
Always use protective stops. The actual placing of stops is a difficult decision and requires great skill. Overly close stops result in unwanted closing of trades on slight volatility but loose stops permit greater losses. A balance must be achieved.
Reward to risk ratios are commonly adopted. The best futures traders often make money on only 40% of trades, so it is essential to make the profitable trades more than compensate for the much larger number of losses. A profit objective is determined and is set at least three times larger than the maximum allowable loss (3:1 reward:risk). The upcoming move must be estimated to be at least as big as the profit objective or the trade is not taken, when in the trade profits are run as long as possible and any losses are immediately cut.
When a trend stalls, and technical indicators start to show an overbought (or oversold) situation it is difficult to know what to do. Futures traders usually trade in multiple units. These units are divided into trending and trading positions. The trending position is held as long as possible unless closed by a loose stop, but the trading position has a much tighter stop. If the market moves against the trend significantly both positions will be closed or reversed with some profits locked in, but if the trend continues the trending position makes significant profits, and the trading position can be reinstated. The use of multiple trading units allows much greater trading flexibility, and trading strategies built on this can make significantly greater profits.
What to do after a good winning streak, or taking severe losses? If your account is down by 50%, do you change your style of trading? Now just to break even you have to double your money. Do you trade more conservatively, even though this will probably make it much harder to win back your losses? This is the old gambler's dilemma.
The situation is happier if you have in fact doubled your money, but do you add this money to your trading account, knowing that the amount of money you can lose in one trade is also doubled?
The worst time to increase one's commitments is after a winning streak, this is like buying into an overbought market in an uptrend. A smarter trading strategy is to increase one's commitments after a dip in equity, even though this opposes human nature, thus increasing the odds that the heavier commitments will be made near equity troughs instead of the peaks.
A list of 20 guidelines given by Murphy pull together most of the important elements of money management and trading.
Futures magazine has a good article on money management.