Money Management and Trading
Trading and earning money, is good, trading while limiting losses, is better. That is the objective of Money Management.
Definition of Money Management
Money Management is the art of managing capital by applying tight capital risk management. It is the most important element in trading after trading psychology but novice traders often neglect it and only focus on gains and technical analysis. However, in order to survive on in the stock market, and it is a war, you against other traders as trading is a zero-sum game, you must, above all, know yourself and know how to manage your capital.
Money Management or the art of pessimism
Your capital is the determining element of your trading, it is your stock in trade. The more you have the more possibilities you have to develop, the more you can spread out risks, like a business. Your capital should be considered in the same way as business capital, each Euro is valuable. I am always surprised to hear people grumble because a loaf of bread has gone up in price by 10 cents, but then manage their capital without even considering the risks they take.
Before opening a position, the first question to ask yourself is: "what risks am I taking with my capital?" rather than "what are my profits going to be?" Always be pessimistic about your potential losses.
I personally evaluate swing positions in this way: If I open the position and the index loses 20% in the next few hours, what will my situation be? If I can I survive, I open the position. If I can't recover from it, I don't open the position or I decrease leverage. Of course, you can place stop orders. But remember one thing, stop orders are not guaranteed. If certain events take place, your stop order could easily be executed 3% lower. You were in leveraged 10:1? Ouch -30% in 5 seconds… IG Markets offers guaranteed stop orders, it is one of the few brokers to do so, it can save your life… think about it…
Money Management is essential to surviving the stock exchange
The stock market is very unforgiving of any mistakes. You can earn money for years and lose everything in 20 seconds if you use too much leverage, if you do not have guaranteed stop orders… 10 years ago there were attacks in the USA, flash crashes (some shares lost 90% in value in 5 minutes), massive sales of Dax futures by Société Générale, destabilising the price of the futures (the Kerviel effect), one trader who drove the stock exchanges to collapse by passing a sell order for 1 billion instead of one million (I have always been sceptical of this explanation)… Each of these events had the potential to ruin you in a moment. If we note all of these major events, you will see that, on average, there is a major risk in the Stock Exchange every 18 months. Statistically therefore, your life expectancy in the stock market is 18 months, if you don't pay attention…
I want to trade my capital for the next 40 years, therefore I apply very a stringent money management strategy to protect my capital. Not losing money is more important for me than earning it. The whole world can earn money, you can simply browse the broker forums, it is always possible to read about the exploits of some traders who are 200% up on the week. Kudos, but 2 weeks, 2 months later, there is no longer any trace of these traders, not because they have become billionaires, but they have had some bad days and have been levelled out. You are there for the long haul, not a fast burnout.
Different Money Management strategies
You must adapt your Money Management strategy to your capital. The simplest way is to set a capital loss limit. Personally, I set a daily loss limit in Euros. If I reach this limit, I stop trading. It is a simple Money Management strategy, but is the most effective as it allows you to fully control your losses, no bad surprises.
The idea of this Money Management strategy is to accept a specified loss which will not jeopardise your capital. You can then restore your capital quickly, you don't risk vanishing into thin air and you assume full control of the situation, you don't suffer more losses. Of course, it is very hard to take losses, we prefer to let things run and wait, sometimes hoping for a miracle… This may work a few times but one day, just the once, the loss will be multiplied by X and you will be left with nothing…
The maximum loss I allow myself is double my daily earnings objective. If I lose one day, I must be able to recover the loss in 1 or 2 days. By the end of 3 days, say a week at the worst, my capital is replenished. So I just wasted time, not money. Of course, for this to work, you must have a success rate of close to 66%. If you have less than a 66% success rate, you might have to consider doing something else than trading because your losses will eventually take over.
The limits of Money Management for small investors
Sometimes you read that you should only risk 1% of your capital per trade. In an ideal world, yes that would be perfect, because there is little chance that you could have 100 negative trades in succession. But this management strategy is useful for Hedge Funds which have significant capital and extremely low costs. If you have €10,000 to invest, taking every €100 loss is virtually impossible with the costs, minimum lot size, etc. If you have €1,000,000 to invest, a €10,000 loss is completely controllable.
This is therefore the paradox of Money Management in the stock market, the more capital you have, the more efficient your Money Management strategy is, if you are sensible. If you have modest capital, with a tight Money Management strategy, it will be more difficult to earn money because your stop orders will be tighter and will be triggered more often…We can summarize as follows: The more money you have, the easier it is to make more whilst taking little risk. The less money you have, the more difficult it is to make more as the risks will be greater even with a good Money Management strategy…
Money Management conclusion
You must find a Money Management system adapted to your capital. You must always expect the worst, because you will see the worst one day or another. On that day, there will be those who will never bounce back and those who will withstand it without flinching and be able to start again. The choice is yours…