There is no trading strategy in the world that guarantees us success every time. No matter how careful and vigilant we are in our trading, there are things that are out of our control. If we carefully analyze a company and follow market trends, we cannot claim to be successful every time. Let us suppose, prices suddenly reverse and move in the opposite direction because of a news event, what can we do? Nada. We can do nothing about it apart from, guess what? Risk management and money management.
- Money management is crucial for a trader’s trading capital and long-term trading goals.
- Those strategies are protective shields that save you from making devastating mistakes.
- Money management is all about maximizing profits while minimizing losses.
What is money management?
Money management is a technique to manage trading capital effectively, minimize losses, maximize gains, and also grow trading money. Money management is often confused with risk management even though both are different concepts. Risk management is a technique to manage and minimize your risks to protect your money from adverse market conditions. Money handling techniques just focus on protecting and keeping intact your trading capital.
Money management strategies
In simplest of words, money management strategies are defensive approaches. The purpose of a money handling strategy is to protect funds to make sure that you have funds intact to trade the next day. Money management strategies involve quantifying your risk per trade, establish a risk/reward ratio, position-sizing, and only then enter a trade.
1. Quantify your risks
There are multiple ways to quantify your trading risks but the following two are the easiest but important methods.
2. Fixed 2% rule strategy
The 2% rule money management strategy is based on your account size. It requires traders not to exceed your position size above 2% of account size. 2% rule strategy proves very instrumental for new traders and for those who have limited funds. Although it is a conservative approach, it can keep you in the trading while you continue to learn and gain experience to play on a high level.
3. Fixed sum strategy
Fixed sum money management strategy revolves around fixing an amount to risk per trade. For example, you have $10,000 in your account and fix an amount say $500 to risk per trade. It is a very easy rule as you know how much you have to risk on each trade. However, it has a major drawback that it doesn’t consider an increase or decrease in your trading balance. If you go on a winning streak, your balance substantially increases but risk per trade remains the same. You will miss out on extra gains if you don’t adjust risk per trade. Similarly, you will be risking higher if the balance decreases because of losses.
4. Risk/reward ratio
After deciding risk per trade, you need to decide how much profit you can aim for, and use this to set take profit order. This is the decision that depends on your trading strategy and your personality, especially your attitude to risk. A risk/reward ratio determines how much profit you aim at the expense of risk you are willing to take. Most people think that the risk/reward ratio of 1:1 is safe. Well, it is but the profit potential is also very low. It is always good to have a higher ratio as you are in trading to get profits. Remember the adage, “high risks, high rewards.”
5. Position sizing
Position sizing is another most important step in your money handling strategy. It means the amount of money you invest in each trade. It is extremely important in money management because position size decides how much can you gain and how much can you lose on each trade. In other words, you are in full control of things with the help of position sizing.
Position sizing is a crucial tactic that helps you minimize risks and also saves you from total wreckage if you fail in your trade. It allows you to cover your loss on one or a few trades from other profitable trades. That means position sizing is in fact a diversification strategy. Follow the following steps for position sizing.
- Determine the amount of your trading capital
- Quantify your risks
- Determine your risk per trade with the help of stop-loss. You should place stop-loss 5% to 8% below your purchase price
- Determine how many shares you can buy
- Determine position size
- You can determine the size of your position with the help of the following easy formula.
Number of shares = Risk per trade percentage × trading capital / Risk per share ($)
Final thoughts
Money management is crucial for a trader’s trading capital and long-term trading goals. If you don’t manage your money carefully, you won’t have money for trading in the near future. Thus, money management strategies are crucial for traders. Those strategies are protective shields that save you from making devastating mistakes.
Money management strategies, if applied effectively, have the potential to manage your limited resources to achieve big profits. After all, money handling is all about maximizing profits while minimizing losses. Money management strategies are pillars of your trading building. Why so? Because they help you grow your money through maximizing profits. Do you want to grow your capital? Do you want to trade for a long time? Pay utmost attention to money management and money management strategies to realize your aims and dreams.