The Basics
Money management is the number one focus of a successful trader. Money management is the essence of managing your capital to prevent losing your capital, giving back gains in a position and at the same time allowing for the maxim upside potential. There are many strategies of application when it comes to money management, but we are going to keep ours simple in the introduction section.

First and foremost, the key to successful money management starts with a defensive approach. If every action you take fails to be based upon a defensive approach, then the odds of success are going to be limited. Most trading approaches consider money management as a separate factor. Our view is that money management principles are the basis or cornerstone of every action taken, not a separate principle.

If a trader makes their cornerstone the key concepts of successful money management, they allow the odds to shift in their favor dramatically. The basic concept of money management is to identify the risk within a trade, based upon your read of a index. Once the risk is identified, the amount is then placed into a formula to identify how much capital should be used. From here the trader can then adjust their risk to reward ratio, keeping the odds stacked in their favor.

Chart A

Chart B

Pinpoint The Risk Per Trade
Identifying the risk in a trade is easy. The risk is figured out by subtracting the entry level from the stop loss level. This will give you your point risk. Multiply this by the divider, which in the S&P E-Mini is $50, then you will obtain your capital at risk. To obtain a percentage value for the risk, you then divide the risk amount by the margin required for the position. The end result will be your risk percentage of risk in the trade (Chart A).

Identifying the upside potential can be done in a number of fashions. Generally it’s the target level minus the entry level. Multiply the difference by the divider. Take this value and divide it by the margin requirement to obtain return percentage. Often times a trader will have initial target and primary target, therefore returns should be figured out for both target levels (Chart B). Identifying the risk to reward is done simply by dividing the risk amount by the reward amount. In the chart examples, the risk to reward is 1 to 2.

Protecting Your Capital
Stop losses are essential when trading. Without stop losses, the trader is placing excessive risk in a trade, which often times leads to disaster. The one characteristic you will find in EVERY successful trader is the utilization of predefined stops at all times.

Setting a stop can be done via a stop or use of mental stop. If a mental stop is utilized, the trader must carry discipline in their trading. Without discipline, a trader will fail to control their risk, because each time a trade is near being stopped out, he/she runs the risk of second guessing their stop.

The Stop Loss
A stop loss is a given level in a position that when hit, causes the open position to be covered/closed. For example, if a trader places a sell stop order for ES at 902 (currently trading at 905), the position will be closed if the 902 level is met.

Trailing Stop Loss
Trailing stops are ideal to use when a trader wants to maintain gains and profit potential at the same time. Trailing stops are applied by identifying a desired trailing level, for example 1-point. The stop will then trail behind the highest high made after the stop was initiated. For example, if a trader entered ES at 901 and used a 1 point trailing stop, the position would be closed if the 900 level was met. If ES moved towards 905, the new stop level would then be 904.

Trailing stops are ideal, because they allow for further profit potential to enter due to momentum, while limiting risk. This approach is especially ideal for positions that move profitable and near exhaustion. Such approach will prevent excessive gains from being given back. The downside is being stopped out prematurely, small price to pay, because you can always trade when you are profiting, but not when excessive losses are being taken. 

Understanding stops and when to use them, along with keeping defensive mindset in your approach is the initial step to obtaining and applying successful money management skills. The actual allocation of capital is the next step, which has numerous variances to its application.

A trader never wants to place at risk more than 5-10% of their capital on a single trade. If you are starting out with a small account, the percentage is going to be higher. If this is the case, WE RECOMMEND THAT YOU ONLY TRADE LOW RISK TRADES THAT HAVE HIGH PROBABILITY OF SUCCESS. If you have a small account, you will likely only trade 2-5 times a week. 

Risk Capital
Risk capital is the amount of capital you are willing to risk if the trade is stopped out. 
 
For example, if you have a $10,000 account and you are placing 8% at risk (because you feel strongly the underlying is going to move higher with little risk) then your risk capital would be $800. 

The $800 amount is not the size of the trade, but instead the amount you are willing to lose within the trade. The size of a position should never be determined based upon how much you are willing to trade and risk. The size of the position should be determined based upon the odds of success. The risk capital only identifies the maximum you are willing to lose if you took the largest position possible.

How Much Can You Buy?
If $800 is your risk capital, you would determine how many contracts you would buy based upon the entry level minus the stop loss level. If you were entering ES at 900 and your stop is placed at 898, your risk in the trade would be 2 points or $100. To identify how many contracts you could buy (not would), you divide the risk capital by the risk within the trade (entry minus exit), $800/$100= 8 contracts. 

In this case, you can buy up to 8 contracts of the e-mini and keep the risk around 8% of your account, if the position is stopped out. The total margin requirement required for this trade (at $2,000 per contract) of 8 contracts would be $16,000. This is identified by multiplying the number of contracts by the margin requirement, 8 x $2,000 = $16,000. This exceeds the account size, which cannot be done. To identify the number of contracts that can be purchased, you divide your total account value by margin requirement and the maximum number of contracts that can be purchased will be identified, 10,000/2,0000= 5 contracts.

Closing Notes
This is only a simple introduction to Money Management. The real heart of money management and art of application occurs when the trader creates a system of trade that identifies where the stop loss within a trade is placed. Most traders try to use a mathematical number or approach to identify where to place a stop loss in a trade and they miserably fail at applying it on a universal level.

Chart C

Fact is that each trade carries its own specific location for an ideal stop, which depends on the setup in the security. For example, a stock bouncing off of lower support will use a stop placed just under the support level (Chart C). If the index is 3 points away from lower support, then a 3 point stop is used. If the support level is 5 points away, then the stop is placed 5 points away. Setting a set stop parameter and applying it universally cannot be done with great success, because the index acts and reacts depending upon the underlying market conditions, never producing consistency on a predeterminable level.

This theory of approach is very rarely taught, simply because there are few systems that actually know how to identifying the key stop loss level.