There are two key aspects to successful financial trading: an effective trading strategy and sound money management. In trading terms, money management is mostly equivalent to risk management, though it is also concerned with making sure that you have access to trading funds when you need them. Trading without a strategy or money management is little more than gambling, whereas using money management means treating trading as a business.
Accepting and minimizing risk
Good money management is actually more important than a winning strategy when it comes to successful trading. The reason is that without money management, you only need to be wrong once in order to be wiped out. Money management in this case is about recognizing that everyone will suffer losses at some time and preparing for that eventuality.
A 60% success rate and excellent money management is more likely to result in long-term profit than a 95% success rate without any kind of money management. Yet a surprising number of first-time traders don’t use any effective money management at all. These inexperienced traders will inevitably find themselves out of the game sooner or later as they burn through their capital resources very quickly.
Before we look at the risk management side of trading, it’s important to have funds available. You should open a dedicated trading account in which you keep your trading capital. You’ll need to be able to draw upon this at a moment’s notice, 24 hours a day, so make sure that your capital amount is always there. For overseas and forex trading, it’s a good ideato set up a nostro account, in order to avoid delays and fees with changing currencies.
How much should you risk?
When starting out, your objectives should be to stay in the market long enough to make a profit, and to protect your capital base. There are various means employed to do this, and some are more effective than others. Some traders base their risk management on the number of pips on a given trade, but this ignores market volatility and also the trader’s own resources.
An obvious form of risk control is to say that you will only invest up to a certain amount (e.g. $1,000)on a given trade. This will limit your losses, but it can also limit your potential profit. It may result in you closing a losing position just before the market turns to your advantage. Following the market should help to give you a better perspective on when to buy in, and when to pull out.
The percentage system
Experienced traders recommend investing only a small percentage of your capital base on any one trade. The usual figure given is 1%, but it’s acceptable to go up to 2% if you’re particularly confident. This means that if you lose your money, it’s only going to be a manageable fraction of your capital. What would be a smart thing to do is to make a financial model of your business before any investments are made. Financial modeling is a complex mathematical model that represents a real-world situation that your business might find itself in.
In this case, money management also means managing your expectations. Your potential profits will depend on the amount of capital that you have available at the beginning. However, using this method should see your capital growing steadily, enabling you to risk more and see greater profits as time goes on.
Taking losses in your stride
Be prepared for losses, and manage your investments in order to cope with them when theyarrive. Part of your money management strategy should be always having a diverse, balanced portfolio, where higher-risk investments are balanced out by lower-risk ones that don’t make such good profits but are safe and reliable. Losing money is an inevitable part of trading, so it’s important to have a long-term outlook, rather than focusing on short-term gains or losses.
A long-term money management strategy requires patience and self-discipline. Avoid aggressive trading, taking extreme risks in the hope of large, quick profits. Instead, establish a long-term trading plan and stay within it. If leverage is available to you, then make use of it, but be sure that you fully understand what it is, and the risks involved. Over-leveraging your investment can be the biggest threat to your capital base. Use stop losses to protect that base and to stop you losing more money than you can afford.
Money management in trading is about understanding the markets and protecting your capital, while working to make a steady profit in the long-term. In order to do this, you need to avoid being wiped out in your first year of trading. That way, you stand a chance of achieving sustainable success.