What is Money Management?
Although you may think the title of Money Management is pretty clear and easy to implement – how to manage your money and invest wisely, it is slightly more than that. It is the educated process of how you save, invest, budget and spend domestic income. This can also fall on overseeing money usage for a business too.
Everyone in some form or another practices money management in day-to-day life, whether in their personal capacities or with investment management such as trading. Trading forex and CFDs successfully does require discipline. You’ll need a proper knowledge of the basic elements that are vital if you are expecting long-term gains from this industry.
Inexperience is possibly the main reason for Australian traders losing money in forex and CFDs trading. Neglecting your money management principles increases risk and decreases your reward. As forex is extremely volatile at the best of times, therein lies an inherent risk, and having correct money management skills are essential when entering the markets.
When entering in to a forex or CFD trade, there needs to be a certain understanding, that you will enter risky situations and accept this as a prerequisite for leveraged trading. There are many risks when trading, however, there are various ways to reduce these risks.
While your profits are generally connected to the risks, here are a few principles:
- Practice position sizing
- Recognize your trading risks
- Analyze and evaluate those risks
- Establish solutions to reduce those risks
- Apply and manage those solutions on a constant basis
Position sizing can be approached in a few ways, as simple to as complex as you choose, as long as it is best suited to your trading platform. This way you are able to easily manage both the losing trades and the winning ones. There are three models we can follow
- Fixed lot Size
Great way for beginners to start their trading careers. This means that traders will trade with the same position size, probably small. Lots can be changed during the trades according to how the account increases or decreases during the trading period. The account size is important when starting out, keep it small and use a leverage of 2:1, this way you can steadily grow potential profits over time.
- Equity Percent
The idea behind Equity Percent is based on the size of your position based on the percentage change in equity. It is best to determine the percentage of equity for every position and this will determine and allow for growth of equity in relation to position size. One can always increase the percentage of equity used for every trade, but it is not without mention, that the higher the profit potential, the higher the risk.
What is a safe percent of equity to trade with?
It is often advised to trade with a smaller percentage of equity such as 1% or 2% that equates to 50:1 leverage per trade also allowing you to stay in your position for a longer period of time. Simply put, keep the size of your trades proportional to your equity, if you enter into losses, the position size is reduced preserving the account from depleting to a zero balance too rapidly. One can also reduce the size of the initial trade when you enter a losing streak to minimize the equity damage.
Remember that breaking even after losses takes more time than losing the same amount.
Advanced Equity percent with stop loss
The methodology behind this technique is to limit each trade to a set up a portion of your total account equity, this is often between 2-10%. This method differs from Fixed Ratio in that it is used in trading options and futures and helps you increase your exposure to the market while protecting your accumulated profits.
Guidelines for setting trades daily or weekly exposure levels
Let’s look at a simple example: if a trader’s trading balance is $1000 and he decides to risk only 2% of the balance ($20) in every trade. In case he trades a mini lot (10,000 units) of EUR/USD, then every pip is worth 1 USD. Thus, the trader should put a stop loss order if the price drops 20 pips. Losing 5 trades in a row will result in losing roughly $100.
Now, let’s say the same trader is ready to risk 10% of the budget on a single trade. He trades a standard lot of 100,000 units of EUR/USD, then every pip is worth 10 USD. In this case the trader should put a stop loss order if the price drops 10 pips (=$100) on the first trade. If he lost the first trade, the new stop loss target is 9 pips (=$90) which is 10% of the remaining balance of $900, and so on to 8,7, and 6 pips in following loosing trades. Losing 5 times in a row with this kind of exposure will result in total loss of $400.
|Number of Losing Trades (balance $1,000)||2% exposure||10% exposure|
Same manner of exposure calculation can be scaled to include daily/weekly exposure levels. If, for example, the daily exposure level is 10% of the balance, then in the first example the trader would need to stop trading on the same day when he lost $100.
Risk and Reward ratios using Stop Loss
When you are ready to start trading you will open your live trading account on the appropriate platform and deposit your acceptable capital. Providing protection of your invested capital when forex or stocks trading move against you is essential and represents the basis of money management. Trading with a serious approach to money management can start with knowing a safe risk and reward ratio as well as implementing stops and trailing stops:
This is the standard method for limiting loss on a trading account with a declining stock. Placing a stop loss order will set a value that will be based on the maximum loss that a trader is willing to absorb. When the last value drops below the set amount, the stop loss will be triggered and a market order is put in place so that the trade is haltered. The stop loss closes the position at the current market price and will prevent any accumulating losses.
In trailing stop there are more advantages when compared to the stop loss and it is a more flexible method of limiting losses. It allows traders to protect their account balance when the price of the instrument they have traded drops. An advantage of the trailing stop is that the moment a price increases, a ‘trailing’ feature will be set off, permitting any eventual safeguard and risk management to capital in your account. The main benefit of a trailing stop is that it allows protecting not only the trading balance, but the profits of the ongoing trade as well.
Risk and reward ratios
Another way you can increase protection of your invested capital is by knowing when to trade at a time of potentially profiting three times more than you will risk. Give yourself a 3:1 reward-to-risk ratio, based on this you should have a significantly greater chance of ending up in a positive return. The main idea is to set the target profit 3 times larger than the stop loss trigger, for instance setting a take profit order on 30 pips and stop loss on 10 pips is a good illustration of 3:1 reward-to-risk. Keep your reward-to-risk ratio on a manageable scale here is an easy illustration of the reward-to-risk ratio to better understand it:
Money Management tips
Whether you are a day trader, swing trader or a scalper, money management is an essential restraint that needs to be learned and implemented per trade opened. Implement the money management techniques or you increase the risk of losing your money. These tips are basic and easy to follow when trading and in risk management:
You should never invest what you can’t afford to lose
First rule of thumb is never fund your account with money that you don’t have. Remember that if you can’t afford to absorb the losses of the invested capital then do not fund your account with money that you can afford to take a loss on. Trading is not a gamble, it needs to be entered into with educated decisions.
Stops and limits are meant to be implemented per position
As your broker we advise you to set stop loss orders. Take them as seriously as you do your investment, trading should be done with precision and not luck. You need a stop loss for every trade, it is your safety net that will protect you from big price moves.
When you profit
When you reach your target profit, close the trade and enjoy the gains from your trading. Withdrawing from AvaTrade is simple, fast and safe. Open your account and enjoy all the benefits and trading advice from market professionals, test our services on your risk-free demo trading account.
Setting your stop loss and take profit orders
One of the most basic of trading principles are how to set your risk reward rations properly. This can be done by establishing where you can define your trade is going, how far the market will go in your favor. Having this number in mind sets the tone for organizing your Stop Loss (S/L) and Take Profit (T/P) orders.
As we mentioned, the traditional ratio in currency trading is 3:1 for the beginner, using a lesser risk reward ratio will become too risky. For the more experienced trader this can be increased to a minimum of 4:1 but never above 5:1.
Steps for setting up your S/L and T/P:
- Write down your target profit in pips. This number can be either arbitrary or derived from forecastable price levels and current market price.
- Take the number from previous step and divide it by the reward-to-risk ratio to calculate the maximum allowed negative price movement.
- Now you are ready to set up your S/L and T/P orders, by taking the numbers of your target profit and tolerable risk values, and calculating the distance from the current market price (in pips) for both the risk and reward value. From these two numbers you set them up as your Stop Loss and Take Profit levels.
To illustrate the aforementioned rules here’s an example:
The current price EUR/USD is trading at is 1.02660.
We assume that the market will trend upwards, and we want to ride the trend, since we believe that the market will go to 1.02759 at a minimum.
So we would take our target price of 1.02760 and subtract the current market price of 1.02660:
1.02760 – 1.02660 = 100 (pips)
To calculate the value in pips of the risk factor based on a 3:1 reward/risk ratio we divide the total number of pips (100) by the reward ratio (3) = 33.33 pip (risk)
We have easily worked out the risk and reward targets and now we set the S/l and T/P levels
Finally, to calculate the final stage take the current market price and subtract from it the risk value. Then add the reward value to the current market price and the final figures will be the S/L and T/P.
1.02660– 0.00033 = 1.02627 S/L
1.02660 + 0.00100 = 1.02760 T/P
Money Management main FAQs
- What is the purpose of money management in trading?
Basically money management in trading is a defensive strategy that is meant to preserve capital. It is a way to decide how many shares or lots to trade at any given time based on your available capital. Successful money management can save you from draining your account when you hit a bad streak of losing trades. It can also help you avoid overextending yourself when your trades are going well since that could lead to a shocking losing trade that wipes out the profits generated over a number of trading sessions. In many ways, money management is also a component of trading psychology as it works outside your emotions and feelings.
- Is money management important to traders?
It should be. Money management can be the skill that makes or breaks a traders’ account. Even if a trader has amazing technical or fundamental analysis skills and can produce an 80%-win rate on trades, unintended errors from poor money management can allow the 20% of losing trades to wipe out the traders account. On the other hand, it’s been documented that strong money management skills can keep a trader profitable even if they have less than 50% winning percentage. Money management should be something always developing and evolving to something better.
- What are some useful money management tips?
There are a number of things you can do today to improve your money management when trading. One is to put in a hard stop loss just as you put in a cap on the amount to risk on each trade. In both cases 2% is a very good number to use. In connection with the first tip, never average down on a long trade or average up on a short trade. Another tip is to work harder to find trades with a good risk/reward ratio and avoid any high-risk trades. There are plenty of trades out there that don’t expose your account to excessive risk.