January 28, 2014

3 Essential Money Management Tips to Improve Your Trading Profits

There are many things that define a successful trader, but perhaps none more important than having good money management. In fact, without it trading becomes more like gambling and the house usually wins. For those that do use proper money management, the sky really is the limit as the markets will look more favorably upon them. However, most don’t know where to start and it’s important they learn to incorporate this into their overall strategy before they lose out big time.

What is money management?

Money management could also be dubbed risk management. Capital preservation truly is the name of the game. When the going is good everything becomes easy and profits just pour into the account. The other side of that coin however, is where a lot of traders get caught up. This is why having a disciplined money management plan is critical for those times that are a little more frightening.

The strategy takes into account a few different things. This can include size of the trade, the percentage of the account to use per trade, keeping a clear head, and stop losses to name a few.

The importance of having the strategy

How is it that some traders are able to loose upwards of 70% of all trades but still be in the money? The answer is simple. They let the wins ride, and cut the losses quickly. This gives them the benefit of being able to lose more trades while capitalizing on a few good ones. They only have to be right a small percentage of the time because they manage their money effectively. It’s incredibly important to have this plan in place so the trader knows exactly what the parameters are for each and every trade.

This also does something else for the trader. If they know exactly how much they’ll lose on a particular trade, because they’ve done the math beforehand, then they are far more likely to have a clear mind while in the position. It does have a ripple effect. Unfortunately, so does not having a good money management strategy. This will lead to stress, and thus affect any judgment they make from that point on.

The healthy percentage

There are some common thoughts among traders about how much capital to risk on any one trade. In the markets, there’s always a temptation of huge leverage at the trader’s disposal. This works great if they are right about the direction of the asset. However, leverage has two stories to tell, and that’s why the smart traders use only a small percentage of their capital to risk on any trade. This percentage is usually between two and 3% of their account capital. Putting a stop loss on the trade with no more than a 3% draw is good money-management. If they lose the trade, at least they’ll fight another day.

This math needs to be done before ever entering into a trade, and must have the stop loss attached. For example, the trader has a total of $10,000 in their account. At 2% this allows them to buy $200 of their asset. If the share price is $10 each then they can enter into a position of 20 shares.

Break the rules break the bank

Every successful trader has a strategy in place, and a big part of that strategy is protecting their bank account. There will always be temptations to take a position in a different direction, but they will likely be at the trader’s peril. In fact, breaking away from this strategy could have severe consequences on the trader’s capital, and it can happen fast.

Winning in the markets is an exhilarating feeling. That’s why people trade in the first place. They come to win. However, if they aren’t paying attention to the other side of the coin, they will have an awfully difficult time staying in the game. Cut the losses short, and let the profits ride. They both are essential to cracking the trading code and success will be awarded to those who do this best.

Max Hansson

Max Hansson is a guest author to the site. Writing about risk, chart strategies and money management. Max is an active day trader of forex, mainly EUR/USD and GBP/USD.