Trading is a funny old game where if you ask the majority of amateur or occasional traders where they place the greatest emphasis, you’ll hear them talk about finding out what’s the best strategy to trade with and on the most profitable choice of markets to place their trades on. These are considered by many to be the very cornerstones of success and, ultimately, the longevity of any trader – i.e. how long you’ll last trading stocks, forex, commodities or any asset. Either before you lose interest and make the personal decision to give up or when bad planning and a cruel twist of financial fate takes your choice out of the equation.
Ask the same question to professional traders and you get a different answer entirely – ‘Money Management is king!’
Yes, whilst strategies and the type of asset you’re trading are nonetheless significant factors in your success as a trader, the single most important determinant of long term survival as a trader is rigorously managing your money and controlling all the factors that could potentially stop you from doing so. Even the best trading strategy on the planet will be of much help if you cannot keep hold of the money in your trading account. In order to manage our trading capital judiciously and to keep the risk of losing it under firm control, a successful trader will need to operate within a fairly robust framework of trading rules and guidelines.
Any serious-minded trader will have to think about how much of the money in their trading bank is going to be put at risk on any given trade. They will need to take into account how many pips to risk on each trade; how big or small their positions should be (Position Sizing). They’ll need to accurately place their stop-loss orders, decide on the size of the stop-loss compared to the potential size of the profit on each trade (Reward to Risk Ratio). They’ll need to not over-leverage their trades; making sure that they’re not coming to a trading decision based on their emotional state or a host of other unhealthy reasons.
Let’s take a closer look at the elements we’ve mentioned above…
1. How Much Of The Trading Bank To Risk At Any Time
It is extremely good practice to set a limit of what percentage of your trading bank you’re going to be risking on each trade and stick to that limit with extreme conscientiousness. Why is this good practice? Well, the truth is that not even the most naturally gifted, luckiest and experienced traders in the world win every trade. There will ALWAYS be a losing trade at some point and, sometimes, a few losing trades in a row. That’s why it’s so important that you risk only small amounts at any given time so that a string of losses does not wipe out your trading account. Most professional traders advise not to risk more than 1% of the trading account on any given trade.
To put this into real terms, that would translate to £100 of a £10,000 trading account. With 1% risk each time, there would need be 100 losing trades in a row to wipe out your trading account. That would be a highly unusual situation.
2. Position Size Per Trade
After deciding on how much of your trading capital to risk, the next important factor to decide upon is how big (or small) the position size of a trade should be. A position size that’s too large for your trading account could very easily lead to ruin after only a few losing trades.
Let me give you this example, there may be a trade set up that we want to take advantage of and we determine that a 20 point stop-loss would be good enough to manage our risk.
Bearing in mind that our maximum risk of 1% on a £10,000 account is £100, we would calculate the position size by dividing the risk capital by the stop-loss amount in points: £100/20 = £5 per point. If the stop loss was 50 points, the position size would be £100/50 = £2 per point
3. Always Use A Stop-Loss
Having a stop-loss in place can be likened to putting safety holds into a cliff face whilst you’re making your ascent. Nobody’s doing this expecting to fall but, when the unexpected happens, you’ll fall a bit rather than plummeting to the ground. A stop-loss is what stops your trading losses from going into freefall; allowing you to make provisions for a planned loss should the trade go against you. The stop-loss is determined before the trade is executed and it’s the only way to protect your account balance from crippling losses should the market not go the way all the indicators were pointing.
4. Reward to Risk Ratio
In addition to knowing when to exit a trade in the instance it should go wrong, it’s also crucial to know when to exit a trade when things go right. The reward to risk ratio represents the potential profit we hope to make from the trade relative to the risk (stop-loss) on the trade. For example, if the potential reward (profit) from a trade is 40 points and we risk 20 points on the trade, the Reward to Risk ratio is 2:1. Reward to Risk ratios can be 3:1, 4:1 or any other profitable ratio the trade permits.
5. Avoid Over-Trading
Trading too often could easily lead to losing trades as you may be rushing ahead and not enough time planning. Simply put, you may be trading unwisely. By not properly thinking out the trade against your strategy and making sure that the host of other factors line up, you’re likely exposing your trading account far more than is necessary.
6. Beware Of Leverage
Most financial trading is leveraged. Leverage allows us to control much larger amounts in a trade than the money in our trading bank would allow. We’re effectively “borrowing” money from the broker in order for us to open a larger trading position than we’re nominally capable of. This allows the trader to make significant profits, much larger than their small trading bank would otherwise permit but by the same token, it’s a double-edged sword whereby losses can accumulate quicker, exceeding the money in the trading bank – especially if there wasn’t a stop-loss put in the proper place. The moral to the Leverage story is twofold: keep position sizes sensible and always trade with a stop-loss in place.
7. Keep a Trading Journal
Recording the reasons why you enter a trade, both personal and circumstantial to the market at the time, as well as the outcomes of these trades will help you to identify the rights from the wrongs. Bye carefully recording all the conditions surrounding the trade you can ad-hoc rectify any scenarios that appear linked to poor money management and therefore your trading losses.
8. Have Strict Rules Around Your Trading Plan
Your trading plan should spell out the set conditions under which you will enter and exit a trade, how much of your trading bank you will be using for every trade and where you will be putting your stop-loss orders. No matter how good your trading plan, if your don’t have the discipline to follow it to the letter then your trading outcomes are going to be less than optimal. Stringently following equally strict trading rules will help to reduce the mistakes you make whilst trading.
As you can see from the highlighted reasons, it becomes crystal clear that strong money management skills are central to consistently profitable trading. The ability to follow the principles of good practice in trading enables the trader to not just hold on to their hard-earned trading capital but to steadily grow that amount and remain capable of creating an alternate primary or second income for you in the long term. Trading can be a lifelong and deeply fulfilling career but it hinges on correct money management and capital preservation. Financial independence but not at any cost.
The Importance Of A Trading Education
Money management, identifying risk, chart patterns, psychology, routine, personality, strategies, software and training are incredibly important for being able to reliably make money from trading. Whether this is your first time taking on the forces of the market or you’ve had limited success and want to improve that potential, we have a course that’s right for you. If trading sounds interesting to you, then please remember to check out Learn To Trade Online; it’s a FREE on-demand training course that we offer and covers day trading, swing trading and many of the basic concepts. In the mood for something a bit niche? Sign up to our next live and interactive topical webinar!
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