Money management is one of the most important concepts in trading. In this section, we will explain in detail what money management is, why you should employ risk management techniques, and how you can mitigate risk using money management strategies.
WHAT IS MONEY MANAGEMENT?
Money management refers to keeping the downside risk on each of your trades at manageable levels to preserve your capital. Money management is based on the idea that protecting your capital should be your first goal and that every trade you open should be based on money management principles.
RISK AND MONEY MANAGEMENT IN TRADING
The lack of employment of risk management principles is one of the main reasons why most traders remain unprofitable in trading. Some traders rely on exotic trade setups and trading strategies that might work in some cases, but without risk management measures, will not produce the desired results in the long run.
WHY SHOULD YOU USE RISK MANAGEMENT TECHNIQUES IN YOUR OPERATIONS?
Money management separates you from your trades, which means you are not concerned with the outcome of your trade as it is based solely on your trading system and risk management techniques.
When risk mitigation techniques are used, the stop-loss is automatically triggered. So you don’t have to hang on to your losing trades, hoping against hope that they will recoup their losses, only to see them deepen the losses.
HOW CAN RISK BE MITIGATED USING RISK MANAGEMENT TECHNIQUES?
Let’s discuss some common but effective risk management techniques that you can implement in your trades:
Choose Stop-loss and Take-Profit points
You should plan your stop-loss and take-profit points for each trade even before placing a buy or sell order. When you set take-profit and stop-loss points up front, you take emotion out of the equation, eliminate the need for trade management, and reduce stress.
A stop-loss ensures that losses are minimized while you strive to generate disproportionate profits.
Here is an example of what it would look like in a winning short position:
Never risk more than 1% of your account on one trade
Experienced traders never risk more than 1% of their account balance on a single trade. For example, if your account balance is $5,000, you can open a trade worth $5,000, or more if you use leverage, but risk only 1% of your balance ($5,000 x 1% = $50) or $50 on each trade.
This would ensure that you stay in the market for the long term and not blow up your account quickly in just a few trades. We discuss this technique and Kelly’s criteria in more depth in our SimCast interview with Kris Verma.
Determining the optimal position size
Optimal trade sizing means opening a trade position that matches the risk level and stop-loss point.
For example, if you have determined that you can only risk 1% of $5,000 ($50) on a particular trade, you can buy 100 shares worth $50 each with a stop-loss point of $0.50. Alternatively, you can consider buying 50 shares worth $100 each with a stop loss point of $1.
A higher account balance gives you more leeway in setting stop-loss points and position size. Even if you use leverage, you still need to risk up to 1% of your account balance on each trade.
Make trades with high risk-reward ratios
Even the best risk management strategy cannot protect your capital if the risk-reward ratio of your trades is not favourable. The risk-reward ratio determines how much money you want to make for every dollar you risk on a trade.
For example, if you are risking $50 or 1% of your $5,000 account, you should aim to win at least $150 or 3% of your account balance. Experienced traders recommend taking high probability trades with a risk-reward ratio of at least 1:3. A risk-reward ratio of 1:3 means you earn $3 for every dollar you risk.
With a 1:3 risk-reward ratio, you can be profitable or in a good position even if you have a winning trade after every two losing trades because you win up to three times on your winning trades compared to your losing trades.