Last Updated on 7 September, 2021 by Samuelsson
Warren Buffet, the Oracle of Omaha, once said: “The first rule of the game is to protect your capital, and the second rule is to never forget the first rule!” Unfortunately, most traders pay lip service to money management. They think that trading is just to open trades after trades and watch them all make staggering profits each time. To them, a losing streak cannot happen, so no need to manage their trading capital in a way that can keep them in the game for a long time. Now, you may be wondering what money management in trading means.
In trading, money management is a way to manage your trading capital such that you can stay in the game for a long time even if you have a losing streak. It is basically about how much of your trading capital you can risk in each trade that would afford you to take as many trades as possible if you’re on a losing streak while also allowing you to trade a position size that can bring a reasonable return for your account to grow. Money management helps you to leverage your account properly while balancing the risk involved in it.
To make the topic easier to understand, we will discuss it under the following headings:
- Money Management: What is meant by money management?
- Understanding money management in trading
- Why is money management important?
- Money management vs. risk management in trading
- Money management strategies in trading: how do you manage money in trading?
- How is money management used in Forex trading?
- Tips to enhance trading performance: what are money management skills?
Money Management: What is meant by money management?
Generally, money management is a strategic skill anyone can use to get the best possible outcome from the money spent. It is a management technique that enables one to arrive at the right amount of risk to take in any situation where there’s uncertainty. It helps answer the question: “What percentage of the available money should be risked in each attempt to get the best benefit?
However, money management in trading refers to a technique for managing your trading capital so that you can stay in the game for a long time even if you have a losing streak. With a money management technique, you want to know how much of your trading capital you can risk in each trade that would afford you to take as many trades as possible if you’re on a losing streak while also allowing you to trade a position size that can bring a reasonable return for your account to grow.
It determines how you increase or decrease your position size to limit your exposure to risk while achieving growth in your trading account. As with many things in life, you can either get your money management right or wrong. If you get your money management right, you’ll be able to implement appropriate risk and reward parameters for your trading account. You will be able to use the right leverage while balancing the risk involved. It doesn’t matter whatever market you’re trading; you need to use the right money management approach to succeed.
Understanding money management in trading
In stock and futures trading, money management plays a very crucial role in the success of any trading system. Warren Buffet, once said that the first rule of investing is to protect your capital and the second rule is to never forget the first rule. As a healthy diet and working out are to keeping fit, so is money management to achieving success in trading.
Unfortunately, most traders pay lip service to money management. This is particularly true for newbie traders as they tend to ignore the basic money management rules and end up blowing their accounts. They think they can just open trades after trades and watch them all make staggering profits each time. Sadly, there will always be a losing streak, so there will always be the need to manage the trading capital in a way that can keep one in the game for a long time.
To understand money management in trading, we will consider the following:
- The key factors in money management
- How to use your account risk and trade risk to determine your position size
- How position size is related to leverage
The key factors in money management
Certain key factors determine your money management plan. They include the following:
Account risk per trade
Your account risk is the percentage of your account balance you would want to risk in each trade. It is important that you know how much of your trading capital you want to risk before you place a trade. In fact, you need to know your account risk to calculate the appropriate position size for your account balance.
Expert traders often advise that you risk no more than 1-2% of total equity on any one trade. By risking a small percentage of your account in each trade, if you have a losing streak, you won’t be thrown out of the game. Let’s say you risk only 1% per trade and you lose 10 trades consecutively, you’ll have only lost 10% of your trading capital.
To get the dollar value of the risk, you multiply the percentage with the account balance. For example, if you have a $10,000 account and decide to risk 1% per trade, then, the dollar value you risk per trade would be $100 per trade (1% x $10,000). This is the maximum you accept to lose in each trade, so you use it to calculate your position size if you already know where you want to set your stop loss or to calculate your stop loss size if already decided the position size to place.
Position sizing (lot size, number of shares, number of contracts)
Position size refers to the size of the trade you want to place in the market. For stocks trading, it would be the number of shares, but for futures, it would be the number of contracts. Forex traders often use lot size to describe their position sizing.
To know the appropriate position size for your account balance/equity, you need to have known how much you can afford to risk in each trade, the size of your stop loss, and the cost of a unit of the instrument. For stocks, the cost of a unit of the instrument refers to the share price of the stock, but in futures or forex, that refers to the dollar value of a tick or pip respectively.
This refers to the size of your stop loss. Strictly speaking, stop loss falls under risk management, but as you can see, it an essential factor in money management. So, both money management and risk management are closely related. Once you have determined a specific amount of your account capital you want to bet with, your stop loss size would affect your position size, or your position size would determine your stop loss size, depending on the one you chose first.
Many technical traders determine where to place their stop loss order based on the market structures or chart patterns. For instance, they may choose to place a stop loss below a certain support level. In this case, the size of the stop loss can be determined from the chart. With that stop loss size, the trader can calculate the position size from the dollar amount he has chosen to risk. On the other hand, if a trader has already chosen to trade a particular position size, he can calculate the specific stop loss size that would allow him to risk only his specified account risk.
How to use your account risk and position size to determine your stop loss
As we stated earlier, you can use your account risk, the size of your stop loss, and the value of a unit of the instrument you want to trade to calculate the appropriate position size for your account balance. The formula for this calculation can be given as follows:
Position size = Account risk (the dollar value) / [stop loss size x unit value of the instrument]
- The stop loss size is in percentage (for stocks), number of ticks (for futures), or number of pips (for Forex)
- The unit value is the price per share (for stocks), the dollar value of a tick (futures), or pip value (Forex)
Let’s take an example with a stock that is trading at $5 per share. For a trader who has $10,000 in the account balance and chooses to risk only 1% of it ($100) per trade, if he decided to 10% stop loss size, the position shares (number of shares to buy) can be given as follows:
Number shares = 100/[0.1×5]
= 200 shares
Note that the tick value varies with the contract type (standard, mini, micro, or nano contract) for any given instrument. The same is also true for Forex; for any given currency pair, the pip value varies with the contract type: standard, mini, micro, or nano contract.
For example, if this trader wants to trade the standard gold contract ($10 per tick) and chooses to use 10 ticks stop loss, the calculation would be as follows:
Number of contracts = 100/[10×10] = 1 contract
For an e-mini contract, the calculation is as follows: Number of contracts = 100/[10×12.5] = 0.8 contracts (rounded up to 1) e-mini contracts.
For a micro contract, the calculation is as follows: Number of contracts = 100/[10×1] = 20 micro contracts
How position size is related to leverage
Leverage is the ability to trade a larger position size than your account capital can normally carry. In other words, with leverage, you can trade position sizes that are worth a lot more than your trading account capital. For instance, 1 standard contract of gold is worth about $183,000 (as of 10th of May 2021, gold is trading at $1830 and 100 ounces make 1 standard contract), but we have shown above that we can trade it with our $10,000 while risking only 1% of the account.
However, to be able to make this trade, our account balance must have been larger than the minimum balance required by our futures broker to trade 1 standard contract of gold. This minimum required amount is known as the margin, and it is often a fraction of the total worth of the contract. Thus, leverage and margin are inversely related. For the standard gold contract that is worth over $183,000, the CME group requires about $9,000 to trade it, which is less than 5% of the contract’s worth. So the leverage would be more than x20.
Leverage versus Margin
As you can see from the table above, the lower the margin, the higher the leverage we can use, and the higher the position size our account capital can carry. In other words, the higher your position size, the more leverage you are using in that trade. Leverage is a double-edged sword: while it can increase your profits, it can also multiply your losses.
Why is money management important?
Money management is important because it enables you to manage your trading capital well so that you can reach your goals as a trader. If you are too aggressive and risk a higher percentage of your account per trade, you might make more money when you are right, but you run the risk of blowing your trading account when you have a streak of losses. On the other hand, if you are too conservative, you may not be making enough money to cover the costs of trading, let alone achieve your trading goals.
The goal should be to make reasonable money while making sure you don’t blow out your account. Most experts advise traders to risk only 1-2% of their account balance/equity per trade so that they can preserve their capital when losses come. One thing is certain, losses will come and can even be in a streak of up to 10consecutive losses or more. It, therefore, is important to manage your trading capital in such a way that even after a prolonged losing streak, you would still have enough capital to be in the game.
Below is a table that shows how a trading account would look like after 10 consecutive losses for two traders using different account risk parameters per trade but starting with the same account balance ($1,000): Trader A (1%) and Trader B (10%).
|Number of losing trades||Trader A (1% risk per trade)’s equity depletion||Trader B (10% risk per trade)’s equity depletion|
|Total loss (%)||10%||65%|
|Gains required to reach breakeven||11%||186%|
As you can see, Trader A, who was only risking 1% per trade, had his account equity go down by only about 10% after 10 consecutive losses. He would only need to gain 11.1% to have his equity return to breakeven. On the other hand, for Trader, who was risking 10% per trade, his account equity depleted by a whopping 65% and would need a 186% profit to breakeven.
Taking it a little further, we have prepared a table that shows the amount of gain required to bring an account to breakeven for different levels of equity loss.
|Amount of equity lost||Amount of gains necessary to return account’s equity to breakeven|
You can see how difficult it is to recover your account back to its original value when your account depletes during a losing streak if you’re risking a high percentage of your account. Obviously, you don’t want to joke with money management.
Money management vs. risk management in trading
Money management and risk management are closely related because they both help you to protect your trading account, but strictly speaking, they are focused on different things. When traders talk about money management, what they have in mind is how you can manage the account equity so you can still be in the game after a streak of losses. On the other hand, when they talk about risk management, they’re referring to how you can prevent a catastrophic loss each time you trade.
At the center of risk management is the use of a stop loss order whenever you trade so that you get out of a bad trade in time and avoid a decimating loss. For money management. It is basically about how much of your account equity you wish to commit in each trade.
One factor brings them together though: position sizing, which is dependent on both money management (account risk) and risk management (size of stop loss) parameters. Moreover, both deal with trading risks — while using a stop loss prevents you from blowing your account in one trade, committing a small percentage of your account equity in each trade prevents you from blowing your account when you are in a losing streak!
Now, let’s take a deeper look at some risk management parameters that you should know. We will discuss stop loss and the risk/reward ratio.
Stop loss orders
A stop loss order is an opposite order you place in the market to exit your position if the market behaves in a certain way. It is mostly used to exit from a losing position when the market has gone beyond a certain level that nullifies that initial signal for the trade. If the initial trade entry order was a buy order (long position), the stop loss order has to be a sell order. On the other hand, if the trade entry order was a sell order (short position), the stop loss order would be a buy order.
Many traders, especially those who make use of technical analysis, place their stop loss orders beyond a specific market structure, such as a support or resistance level, a trend line, a 200-day moving average, or a pivot level. These traders use the market structure to determine the size of their stop loss orders and can then information to calculate the size of the position they want to place in the market based on their account risk.
Some other traders prefer to calculate the right size of stop loss order that can allow them to risk a specified percentage of their account for that trade. Whichever way the trader chooses to get the right size of stop loss order, depending on the type of stop loss, the order can either be executed as a market order or a limit order when the market reaches the level where it is placed.
A stop market order triggers a market buy or sell order, as the case may be, when the price of the security reaches the specified level. On the other hand, a stop-limit order triggers a limit buy or sell order when the market reaches the specific stop level. So, the stop-limit order consists of two price settings: the stop price and the limit price. The stop price is the price that triggers the activation of the limit price at which level the trade would be exited.
There is also a trailing stop order, which traders use to lock in their profits. As the name implies, a trailing stop order trails the price: moving along with the price, at a specified distance away from it, when the price is moving in the trader’s favor and standing at the last level it got to when the price is moving against the trader’s position.
The risk-to-reward ratio, better phrased as the reward/risk, is a measure of how much profit you make from every dollar risked in a trade. A reward/risk ratio of 3 simply means that the trader’s strategy offers $3 for every $1 risked. Experienced traders advise that you aim for a reward/risk ratio of at least 2 so that you don’t need to win more than 50% of your trades to stay comfortably profitable.
For any given strategy, the higher the reward/risk ratio, the more money it can make for every dollar risked. However, you should know that any strategy that offers more than a reward/risk ratio of 2 will likely offer less than a 50% win rate. So, be ready to endure a long losing streak sometimes. For such a strategy, it becomes highly important to risk very little of the account equity in each trade and to implement a strict money management plan.
Money management strategies in trading: how do you manage money in trading?
Now that you’ve known what money management is about, let’s look at how some traders tweak their money management plans to help them either reduce risks or improve returns. These are some of them:
Trading according to account risk: Many traders simply trade according to the size of their account by first determining their account risk and using it to find the right position size for each trade once they know where to place their stop loss orders. With this strategy, the position size increases as the account equity grows, and reduces when the equity declines. This is the normal strategy that is recommended for new traders.
Increasing position size during a winning streak: Some aggressive traders try to maximize their returns when they are in a winning streak, so they increase their position size beyond their normal account risk when they are in a winning streak. A trader who normally risks 1% per trade may end up risking 3% or more per trade during a winning streak. The danger here is that nobody knows when a winning streak would end, so this can lead to a huge loss. Often called the anti-martingale, this strategy is not good for new traders.
Reducing position size during a losing streak: This strategy is for very conservative traders who want to reduce their account drawdown during a losing streak. What they do is to reduce their position size much lower than their usual account risk when they are in a losing streak. Normally, their declining account equity during a drawdown would lead to a lower dollar amount they can risk per trade (although still the same percentage account risk), but with this strategy, someone who used to commit 1% of the account equity per trade may decide to go down to 0.5% of account equity per trade during a drawdown until he comes back to winning ways. This strategy minimizes risk and reduces drawdown, but it is a good one for newbies.
Increasing position size after a loss: This is an ultra-aggressive strategy that aims to recover quickly from losses but may end up blowing the trading account very quickly because nobody knows what the outcome of the next trade would be. The strategy is nothing more than trying to revenge on the market. It is a dangerous strategy and should never be recommended by any serious trader. A more dangerous type of this strategy is the martingale strategy, which doubles double down on any loss by adding more trades in the direction of the losing trade with the hope of breaking even faster or making huge gains when the price reverses. Unfortunately, the price may continue going against the trader and increasing the losses until the trader blows his account. The fastest way to blow your account is to implement a martingale strategy.
How is money management used in Forex trading?
Money management strategies are more or less the same for traders in different markets. There are no special strategies for any market. Traders in different markets simply adapt money management principles to the market they are trading. While stock traders deal with share prices and the number of shares and Forex traders deal with pip value and lot sizes, futures traders deal with tick value and contract sizes.
Nonetheless, these are some money management strategy tips for Forex trading:
- Ensure that the total invested funds should is limited to 50% of total equity
- The total amount risked in any one market should be limited to 2% of total equity or less
- The total commitment in any one market should be limited to 10-15% of total equity
- Be sure that the total margin in any market group should is limited to 20-25% of total equity
- Always remember to let profit run and cut losses short
Tips to enhance trading performance: what are money management skills?
Here are some tips that can help you enhance your trading performance:
- Know your account risk per trade: As we stated earlier, you should know the percentage of your account equity you intend to risk in each trade. It is advisable to keep it at 1% if you are new to trading.
- Always use a stop loss: Be sure to place a stop loss order in every trade. This will help you avoid catastrophic losses if the market goes against you.
- Focus on the process and not the outcome of each trade: When trading, focus on the process of placing each trade and managing it. Don’t bother about the outcome of each trade because it is random and there is no way to know. Once your strategy has a positive expectancy, just trade it and ignore the outcome of each trade.
- Have a trading plan: You must have a trading plan. This plan should contain your trading strategy, risk management strategy, money management techniques, the markets to trade, when to trade them, and every other thing about your trading, including how to keep a trading journal and how often you review it.
- Keep a trading journal: You need to keep a record of all your trading activities, parameters, time, outcomes, etc. Keeping a trading journal will help you point out where you make mistakes and where you made the right decisions. Documenting all these in your journal will not only show you your previous mistakes but also help you to make better trading decisions in the future as you will know where to improve on.
- Know how often to review your trading strategies: You should add in your trading plan how often you intend to review your trade results and examine your strategies. While you should not focus on the outcome of each trade, there should always be a time you review those outcomes to know how well your strategy is performing and if you need to tweak it a little. The best approach is to trade in sample sizes and review after a sample size (say 30 or 50 trades) is reached.