Money management is often an overlooked aspect of the trading process.
This is because most traders are focused on the what and when of trading.
If you look at it closely, you will notice that most traders want to know what instruments to trade? Which currency pair to trade? Which commodity to buy? Which market is moving?
And of course, we all want to know when we can get into a trade. Or when do we get out to take profit or to cut a loss.
There is no question that knowing the what and when of trading is important. But knowing how to allocate the funds to each trade is critically important too.
And for many traders, not having a trading strategy of how you allocate your capital to each trade can spell the difference between success and failure. That’s why it is so crucial to learn proper money management strategies that can boost your trading and to realise what dangers traders can face if they do not have a money management plan in place.
In the book ‘Technical Analysis of the Financial Markets’ author and technical analyst John Murphy talked about his transition from a research analyst to managing clients’ money and how he realised the importance of money management.
“I was amazed at the impact such things as the size of the account, allocation of funds and the amount of money committed to each trade could have on the final results,” he said. John Murphy understands just like we do, how necessary money management strategies are in your trading plan.
What is money management?
Money management is a tactic traders use to preserve their capital. The objective of money management for traders is to limit their risk while aiming to achieve as much growth as possible in their trading account from increasing or decreasing their position size.
3 Money Management Strategies for Traders
1. Allocation of funds
There’s no question there are almost unlimited trading opportunities in the markets.
Whether you’re talking about forex, commodities, equities, indices, futures and other markets, chances are you can find a trading opportunity that will suit your trading style.
Whether you’re a short-term day trader or long-term trend trader there will be numerous trading opportunities.
However, there is one thing that can stand in your way of taking advantage of the multitude of trading opportunities.
Your trading capital.
Money management for many traders, starting with a small trading capital is the only way to get into the markets. So, if you consider the almost unlimited trading opportunities and the limited trading capital, obviously something has to give.
This means you need to have a system of allocating your trading capital to each market you want to trade. In most cases, this may mean trading only in one or two markets at the most, even if there are many other markets you want to trade.
Allocation of funds is usually done on a high level – which means deciding which market you want to trade. Do you want to trade forex or commodities? Do you have enough capital to trade both of those markets?
While you definitely need to know what to trade, you also need to have a system on how much funds to allocate for each market you want to trade.
How to apply allocation of funds in your money management?
Let’s say you have a $10,000 trading capital. This may be too little if you want to trade every market like forex, commodities, indices or equities.
This is when you have to be selective. You need to make a decision on which market you want to trade.
After analysing the different markets, you decided to trade forex and commodities. By doing this you have narrowed down the markets and then you can allocate say $5,000 for each market.
2. Position sizing
Position sizing brings your allocation of funds to another level.
At their core, position sizing techniques involve deciding how much to allocate per trade. How much risk you want to take per trade.
For example, you want to trade EUR/USD, USD/JPY and USD/CAD. Depending on the size of your trading capital and your previous experience in trading these forex pairs, you may want to allocate different amounts to each trade.
But Linda Raschke, a well-known commodities trader, said in an interview that her preferred way of position sizing is to use a standard lot or contract size per trade. This gives her a certain level of control and limits her exposure per trade.
For example, if you want to trade 3 different FX pairs, you may open 1 mini contract per each pair. And depending on the price movement of each pair, you can either cut the losses or ride the winners.
Position sizing is important as you can pre-set how much money you want to put on a specific trade.
How to apply position sizing in money management?
Following on the example from the allocation of funds above, you can use position sizing by allocating a certain amount per trade from the two lots of $5,000 you have decided to use to trade the forex and commodities markets.
For example, you can allocate say $1,000 to a EUR/USD trade, another $1,000 on a USD/JPY trade and another $1,000 to the USD/CAD trade.
For your commodities trades, you can do the same and allocate $1,000 to trade WTI Oil, another $1,000 to trade gold and another $1,000 to trade silver.
Please keep in mind that these examples don’t take into consideration the margin level you will use on your trades. We have used dollar values only to simplify the examples.
Money Management 3. Use of stop-loss
Using stop-loss orders is the third component of a solid money management strategy you can use to boost your trading.
When you use a stop-loss order you’re drawing a line in the sand and limiting the amount of loss you want to take or to be exposed to.
Most trading platforms now have built-in stop-loss levels you can adjust to suit your trading style and risk profile.
The other important benefit of using a stop-loss order is you don’t have to sit and wait in front of your computer to monitor the price movements. Once you set your preferred stop loss level, most trading platforms will execute it once the level is hit.
These 3 money management techniques you can use to boost your trading. If you haven’t incorporated them in your trading routine, it may be about time you do so and see the impact they will have on your trading results.
Now that we’ve discussed some of the best money management strategies for traders, let’s understand the dangers you could face by not implementing a money management plan.
One of the most important skills in poker is knowing how much to place on each hand and to press when the odds are in your favour.
And so too with professional traders, you need to build into your systems a strategic money management plan that allows you to cut your position when it isn’t working and maximise your opportunities when you are winning.
The old maxim rings loud and true when it comes to trading in that you must ‘Cut your losses and let your profits run.’
Let’s review some of the dangers of not having a money management plan in place and what it will mean to your bottom-line results.
7 Dangers for not utilising a money management plan
Money Management 1. Losing all your hard-earned trading capital
The truth is, when it comes to forex trading, you can lose more than what you start with. Once your losses get too big, you are out of the game. Capital preservation is critical for you to stay in the game.
2. Being clueless with how much you need to risk on each position you take
You must know how much is appropriate to risk based on your account size and the volatility of the instruments you are trading. You cannot just trade the same dollar amount or random dollar amounts and expect a smooth, rising equity curve.
3. Believing that one trade will ‘finally set you free.’
We hear this time and time again. ‘All I need is one amazing trade, and I can finally say goodbye to my dead-end job’. Money management is not how trading works. You must steer clear of this mindset and instead build up your consistency and learn how to apply your edge across the markets in a consistent, steady fashion.
4. Averaging down into losing trades
This will always be the eventual death of a trading account. It might not happen this year or next year. But if you average down enough and do it aggressively, you will wipe out. Do not average down. Averaging down is also referred to as a martingale position sizing strategy where you increase the size of your position as you are losing. This is the opposite of professional trading. Professional traders employ anti-martingale position sizing strategies.
5. Not knowing how to add to winning trades
The guiding principle of trading is to cut your losses off short and let your profits run. In addition to letting your profits run, you must explore the option of adding to winning positions. This is dependent on the type of system you have with trend following systems being able to take advantage of this principle the most.
6. Revenge trading is part of your toolkit
Emotionally driven trades are a huge danger zone if you want a healthy trading account. Do everything you can to eliminate any form of revenge trading. Treat each trade as independent of the previous one with a new expectancy and the ability to focus on quality execution of your trading plan.
7. Knowing when to cut back when you are on a losing streak
Another big danger zone for traders is combining revenge trading with a losing streak. The amateur trader will get their blood pumping and think in terms of ‘How big does my next position need to be to win back all my previous losses and then some?’. Instead, a professional trader will stop trading or halve their position size until the numbers of their system match their backtesting results.
We’ve run through 7 dangers of those who don’t have an effective money management plan in place and the best money management strategies to utilise.
Of course, there are more, but the underlying foundation of all sensible money management plans and strategies focus on capital preservation. Trade well and trade small.
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