The majority of traders seem obsessed with carving out a flawless trading method, often mistakenly overlooking the significance of money management.Whilst it is strongly agreed that a well-rounded trading strategy is vital to success, money management can also be your silent ally. Working quietly behind the scenes, the applied money-management strategy serves to regulate your trading resources. Without it, surviving as a trader cam be a challenge.
And so with that in mind, the team has assembled an introductory piece that highlights vital facets on the subject which should help communicate its importance and should you wish, encourage action.
Become a RISK manager first – a trader second
Without question, managing risk is one of the most important responsibilities in the daily life of a trader – if not the most important one!
Whether we like to admit or not, most of us have a deep-seated emotional attachment to money. So the first question you must ask yourself is what percentage of your account equity are you comfortable risking on each trade.
Risking 2% per trade appears to be the recognised standard. The question is, though, is 2% a comfortable risk profile in terms of monetary value for YOU? You may only be comfortable risking 0.5% of your account, and that is absolutely fine!
The hard truth all traders eventually learn is that trading is far more difficult when the chips are down, even if you have a very effective trading strategy. Therefore, selecting a healthy risk profile in your trading plan is essential.
Unless you’re a psychic, you won’t have the supernatural capabilities to foresee the future.
Trading without a protective stop-loss order is an invitation to drain your account. It is as simple as that.
Anything can happen in the markets. You must accept this.
Adopting sound practice in relation to utilizing stop-loss orders, therefore, should be considered priority as it is there to protect you from further monetary loss!
Losing a small percentage of your account permits you to fight another day, and can be seen as insignificant in the overall scheme of things.
Attempting to ride a loss out in the hope that the market reverses back in favour WILL likely end your account and possibly any dreams you have of ever becoming a trader. The psychological trauma incurred from a massacred account can be overwhelming. Don’t underestimate it!
Knowing when to call it a day
I am prepared for the worst, but hope for the best – Benjamin Disraeli.
In addition to a protective stop-loss order and defined risk parameters, understanding when you have reached breaking point is also important. Think of this as an emotional fail-safe device.
Personal breaking points will differ among traders. Some are quite content losing a trade and are able to function normally for the rest of the day. A second consecutive loss, or even a third, though, tends to have an effect.
If two losses are your daily limit before you start feeling the strain then this should be a point at which you step back. Detail this clearly in your trading plan.
The same goes for take-profit targets. A huge win can place one in a state of euphoria and affect people differently. If you’re finding yourself hitting a level of elation after a certain monetary value has been achieved, this could be a point to consider closing shop for the day, or at least taking a break. Again, this should be clearly defined in your trading plan.
Those who ignore this principle will very likely lose money long term.
It is widely accepted to only take trades that offer at least a 1:2 risk profile. What this means is on a $10,000 account risking 1%, you are effectively wagering $100 to gain $200 profit. This is a key element to money management. The 1:2 minimum risk/reward ratio enables traders to recover losses, and potentially end the week, month or year in profit. Traders, especially those new to the industry, tend to focus on their win ratio over their risk/reward ratio which is a big mistake. A trader with a high win ratio and a shabby risk/reward ratio can end up in trouble.
Allocating too much standing on the near term can also be detrimental to your trading. You should almost try and adopt an investor mindset even though you may interact with the market on a daily basis, as probabilities work over a SERIES of trades. We touch on the subject of probabilities more in-depth here: Thinking in Probabilities
Having the discipline to think long term will help you follow your money-management rules when the chips are down. Two, three or even four consecutive losses should not affect the ability to trade if good money management and a sound trading methodology is in place.
Money management is as flexible and as varied as the market itself
The points made in this article should provide one a foundation in which to begin exploring money-management techniques. How you go about achieving this will, of course, be dependent on a multitude of factors that are personal to you. For example, risk choice, risk/reward settings, overall goals etc.
Remember, money management is essentially your very own supervisor (albeit muted) working hard in the background to keep your account in tip-top condition. Don’t make the mistake of thinking it is not necessary!