What is Money Management?
Money Management, also known as Investment management or Portfolio Management can be defined as a process in which investors budget, save and invest their capital usage. It is a protective concept that keeps your funds secure so you can trade another day and underpins profitable performance. It is the art of managing capital by applying strong capital risk management.
Money Management is the second most important part of trading right after trading psychology. But a lot of novice traders often wouldn’t pay much attention to it and neglect it by only focusing on gains and technical analysis. But in the world of trading financial markets, it is after all very important to know how to manage your capital.
Money Management is a vital element of trading the most volatile financial markets like Forex and Cryptos. On a basic level, it tells you that if you have enough new capital to trade additional positions. Money Management is an important factor that differentiates success and failure, especially when using leverage.
Why is Money Management important?
A lot of aspiring traders put a lot of focus into their trading education. They learn trading strategies and candlestick patterns in order to have a better chance of mastering the markets. This is obviously important, but many traders ignore that they need to focus on day trading money management skills also to be successful in the world of trading.
When you pursue trading as your profession, the last thing you want to happen to you is blowing up your account and get taken out of the game. Your entire focus should be on preserving and protecting your capital and trade wisely. Not just novice traders, but also many of the successful traders suffer when they do not properly do their money management.
So it is better to spend some time to understand the techniques of money management along with the Technical Analysis. Money management should be considered as a positive part of your trading armory. If you use it in an intended strategic fashion, solid money management can be used in an offensive and profitable way.
Steps in Money Management Process
Most importantly the trader should decide whether if they want to proceed with the signal they choose. This, in particular, is a serious problem when more than two securities are competing for limited capital in the account. Then for every signal accepted, the trader should decide on the percentage of the trading capital they are willing to risk.
The goal is basically to maximize the profits while protecting the fund against any loss that could incur. This is very important because only if the capital is protected, a trader can participate in the trades further. The best way to protect the capital from getting liquidated is by fixing a particular dollar amount for every single trade and not crossing that number what so ever.
For each signal chosen, the trader should decide the price which confirms that the trade is not measuring up to expectations. This price is also known as the stop-loss price or the stop price. The difference between the entry price and the stop-loss price defines the maximum permissible risk per trade. The risk capital allocated to the trade divided by the maximum permissible risk gives us the number of contracts to be traded.
Money management fundamentally comprises the following steps.
• Ranking the best possible trades
• Deciding on the part of the capital that you are willing to trade
• Distributing the willing-to-risk capital across the trades
• Assessing the level of loss for each opportunity that you can afford to lose
• Deciding on the number of contracts of a security to be traded
Starting with the ranking of available opportunities to trade, the desirability of a trade is measured in terms of its expected profits, the risk associated with it and the investments required to initiate the trade. If the profit is more and the risk is less than would obviously is the best scenario for any given trade.
Similarly, if the investment required to initiate the trade is less the trade is more desirable. Second, by controlling the overall exposure a trader can maximize the profits and mitigate the risk. This means, if you allocate 100% of the capital across your top chosen trades there is a risk of losing your entire portfolio if you lose all the trades you placed.
At the same time, if you risk very minute percentage of your capital for the trades you chose, you might mitigate the risk of losing your capital but you hardly see any profits. So there should be a right balance between these two in order to maximize your profits.
So once you decide the total amount of capital to be risked for the trades you chose, allocate that capital across competing trades. The best way to do this is to allocate the fixed amount of capital for all the trades you chose when you are not sure about the risk to reward ratio.
But once you know the potential of the trade, you can then increase or decrease the amount of capital on one particular trade in order to maximize the profits and mitigate the loss. Then once you are done allocating the risk capital, the next step is to assess the maximum loss that you could afford to lose on a trade.
This step separates winner from losers. Accurately forecasting the loss in unpredictable financial markets like Forex and Cryptos is where the secret sauce of trading lies. It is tempting to ignore the risk by concentrating only on the reward, but a professional trader should not fall for this temptation.
There is no guarantee in trading what so ever, and a trading strategy which is based on hope than realism would rather fail than win most of the scenarios. Following these principles, traders can mitigate most of the risk and can protect their capital in the highly volatile Forex and Crypto markets.
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