Markets can remain irrational longer than you can remain solvent – John Maynard Keynes.
Like exercising, money management is a concept most pay lip service to, but few unfortunately practice. Just like eating a healthy diet and staying actively fit, money management can seem a laborious, disagreeable motion. It forces traders to monitor positions and recognise necessary losses.
Nowadays, most traders are obsessed with owning a flawless trading methodology. While knowing entry and exit conditions are a vital element to trading consistency, money management (risk management) is your silent ally. Without it, surviving as a trader is impossible, irrespective of the methodology employed.
Risk manager first – trader second
Managing risk is crucial. Most of us have a deep-seated emotional attachment to money, so determining what percentage of your account equity you’re comfortable risking on each trade is necessary.
Some might consider it prudent to risk no more than 2% of their overall equity in any one trade. The question is whether 2% is a comfortable risk profile in terms of monetary value for you? You may only be comfortable risking 0.5% of your account.
The hard truth all traders eventually learn is trading is far more difficult when the chips are down, even if you have an effective trading strategy. Selecting a healthy risk profile, therefore, is essential.
Protective stop-loss orders
Whenever a position is initiated, a protective stop-loss order must be determined. The reasons are twofold. Protective stop-loss orders protect capital and allow the trader to define risk value. By establishing a stop level, the trader knows what the value of capital risk is before pulling the trigger.
Assuming you adhere to a 2% risk profile, setting the protective stop-loss order to honour this value is imperative. For example, a $10,000 account risking 2% on any one trade equates to $200. On top of this, though, remain aware of commissions and spread cost. Losing a small percentage of your account permits you to fight another day, and a loss is insignificant in the overall scheme of things.
Attempting to ride losses out in hope the market reverses back in favour will likely end your account and possibly any dreams of ever becoming a trader. The psychological trauma incurred from a massacred account can be overwhelming, and take months to reconcile
Common types of protective stop-loss orders are the chart-based stop, the equity stop and volatility stop.
If you find you have an unusually high loss rate, consider adjusting the position of your stop. It might require adjusting to suit current price volatility.
Protective stop-loss orders are also useful functions when you are not able to monitor the market – think set-and-forget methods – as the order mechanically liquidates an unfavourable trade.
The risk-reward ratio measures how much potential reward there is for every dollar you risk. As an example, a risk-reward ratio of 1:3 means you’re risking $1 to potentially make $3.
It is widely accepted to only take trades offering at least a 1:2 risk-reward profile. This is a key element to money management. The 1:2 minimum risk-reward ratio enables traders to recover losses and profit.
Traders, particularly those new to trading, erroneously tend to focus on their win ratio over the risk-reward ratio. This is an immense mistake.
For more of an in-depth look at the subject check out: https://www.icmarkets.com/blog/riskreward-ratio/
One of the reasons newer traders are overly aggressive is expectations are typically unrealistic. Unrealistic expectations may lead a trader to commit certain mistakes those with experience and realistic expectations may not.
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 daily, as probabilities work over a SERIES of trades. We touch on the subject of probabilities more in-depth here: http://www.icmarkets.com/blog/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.
Although trading offers opportunity, reaching a level of consistency will probably take much longer and require more effort than originally planned. Setting realistic goals and maintaining a conservative approach is the right way to start trading.
Enough is enough
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 important to identify. Think of this as an emotional fail-safe device.
Personal breaking points will vary. Some are quite content losing a trade and can 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 feel the strain this should be the point at which you step back. Detail this clearly in your trading plan.
The same goes for take-profit targets. A huge win can ignite a state of euphoria. 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 to recollect your thoughts. This should also be clearly defined in your trading plan.
Find your own path
Like all aspects of trading, what works best for some may not work for others. Always be true to yourself.
The points made in this article provide a foundation in which to begin exploring money-management techniques that will benefit your bottom line. Do not lose sight of the fact money management is your 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.
Consider using IC Market’s demo account, risk free. This gives you an opportunity to familiarise yourself with the terminal’s functions and test drive trading strategies with (simulated) funds. In addition, this article: https://www.icmarkets.com/blog/5-must-read-books/ may be of interest to get those creative juices flowing.