Methods of captial management in Forex and stock market trading, strategies and examples of how to use money management
Statistics shows that no more than 10% of traders trade with profit on a long-term horizon, and almost 90% of traders do not use any particular strategy to manage their capital.
These figures mean that modern traders lack experience and few of the majority think about what money management is, which ultimately leads to a loss of investment in the long run.
According to Jack Schwager, one of the world’s most renowned traders, “… successful traders consider money management more important than the trading method; they have a flexible point of view and are ready to change their minds in a matter of seconds. Another inherent trait is the ability to lose. Only amateurs in this field are afraid to suffer even a small loss.
This economist, along with other traders, scientists and financiers, urges all investors not to forget how important money management is in trading.
A trader must be highly disciplined, understand stock market trends and follow money and risk management principles.
What is money management in simple terms
Money Management are the rules for managing money. This refers to a set of principles and systems for the distribution of funds intended for investment. The goal is to minimize the risks of losing the trader’s entire monetary capital.
Money management in trading is a set of actions for managing money (capital), including the use of tools and strategies to preserve and increase assets.
Money management, in simple terms, are financial strategies that help you not lose money.
Many people think this is a trading strategy, but in fact money management does not help you make money directly, it helps you not lose it.
The founder of money management is considered the mathematician Johann Bernoulli , who worked in his works in the first half of the 13th century. outlined the ” theory of expected utility “. He wrote that “… to assess the degree of risk of the whole strategy (set of factors), it is necessary to determine the average of the possible outcome of each.”
This theory was developed in the works of the mathematician J. Neumann and several economists.
The main idea is to achieve a smooth increase in investment while aiming for the lowest possible loss.
The theory of money management cannot guarantee the investor permanently successful transactions, but following it will help minimize losses due to unprofitable transactions.
Why do you need money management?
The profession of a trader is very dependent on psychology, very often people, seeing the possibility of making super profits, lose control of themselves.
Asset management planning is the basis of every trading day. Many investors admit that they work to increase their capital in the long run, but at the same time they can lose all the capital in one day. How is this possible? Why can investors suddenly lose all the profits they earned from investments they made over the course of several months?
The answer is usually the same: “I had the worst period, my profits were lower than normal and therefore I risked more when opening new positions. This led to even greater losses.”
It depends only on you whether you behave rationally in periods of uncertainty so as not to take unnecessary risks. At such times, every investor should try to limit their losses, not increase them.
Experienced traders know how to deal with losses and how not to increase them. This is the purpose of money management. It sounds very simple, but every trader will face this problem if he does not define his own money management rules from the beginning.
Money management allows you to keep your head above water even in the event of a wrong decision and in unfavorable market times. This does not increase your profits, but limits your losses.
Basic rules for money management
One of the first strategists of money management in stock market trading is considered the genius trader Jesse Livermore , who made millions at the beginning of the 20th century . His investment strategy enabled him to make a fortune from stock crashes in 1907 and 1929.
He developed a few simple rules that, if followed, can help any trader trade profitably.
Money Management Rules:
- You must not invest all the money at once in one deal. It is better to open several trades or save money for averaging your positions. It will be psychologically easier to exit a losing trade when the market is falling. Jesse Livermore himself did not invest more than 10% of his capital in the deal;
- Give profits a chance to reach a maximum, that is, be patient enough so that open positions can produce and show significant profits;
- Reach your money in time, that is, transfer the profits received into cash. The great trader believed that it was necessary to convert at least 50% of the profit of each large transaction into cash, but modern traders believe that everyone should determine their own threshold.
As long as an investor uses his capital (deposit) as a working tool, money management plays an important role in trading. Correct money management in Forex or other markets is as necessary as the correct implementation of the strategy. All rules and principles of money management can be divided into three groups.
Asset management rules determine what money can be withdrawn from your account and how much of the resulting profit should be left for future trading. Management allows you to set specific goals for available funds. The amount of the deposit serves as an indicator that helps the trader understand when to apply certain methods; here, the trader defines certain income levels that he plans to use as key points in trading.
Let’s say a trader starts working with $500. In accordance with the management strategy, the trader, once the deposit amount reaches $1000, withdraws the profits to open a parallel account or trade with another strategy.
Determining the volume of trade
This part of money management is combined with risk management. The investor must compare the size of the transaction with the size of the deposit to maximize profits and avoid serious losses in case of failure.
Losing a trade is a normal process. Even at times when a trader is using his strategy most effectively, some trades may involve losses. To prevent a series of lost trades from gobbling up your deposit, the size should not be sufficient for 5-6, but for 30-40 trades . Then the odds are on your side.
Restrictions on trade
Based on an individual approach, the trader establishes a set of rules to smooth out the negative effects of the strategic shortcomings.
Such rules include:
- If there are 4-5 unprofitable transactions in a row, no more transactions may take place that day;
- Stop trading for two or three weeks, if in the current month the deposit decreases by more than 15-20%;
- Stop making trades if the daily profit is 2-5%;
- Open no more than 2-5 trades in one day.
The concept of money management includes risk management. These two concepts do not replace, but complement each other.
The main positions of risk management include:
Clear boundaries must be defined:
- The amount of allowable losses (if reached temporarily suspend trading).
- The number of transactions made in a certain period of time, for example, no more than 4 transactions per day.
Keeping a diary of all trading activities can be a good psychological aid, allowing you to analyze your activities.
Thus, with risk management, you can eliminate emotions and assess the loss of money as part of the investment process.
Psychology of money management
The trader must have strong nerves and a clear head. The main psychological trap is that a person cannot stop trying to recover his losses.
Following money management rules helps the investor develop discipline and feel that his assets are safe.
Strict money management protects the trader from irrational greed, as the trader avoids the temptation to trade by relying on his luck.
In addition, money management helps to deal with anxiety when a trader adjusts his strategy (boredom or for other reasons) by opening trades randomly.
Investors need to understand that crises cannot be avoided, but they can be adapted to them. If they understand this, their self-confidence will increase and they can avoid rash actions by controlling their emotions.
The accumulation of experience in making transactions and strict adherence to the strategy will lead the trader to automate the work in the stock market, reducing negative psychological factors to nothing.
Money management strategies
Beginning investors often use the averaging strategy . This strategy is to increase the proportion of your shares as the stock price falls. This method lowers the average purchase price.
The effectiveness of this method is best said by those whose money ran out before the recession. This investment method is especially popular with investors who use fundamental analysis ( although technical analysts do not shy away from it either ). It stems from a simple assumption: if I have made a value of an asset and believe that it is undervalued, then any drop in price increases the undervaluation and thus the attractiveness of the investment.
This, of course, violates the fundamental investment principle of ” reduce losses quickly.” Unfortunately, since the product is not profitable, price averaging has many supporters.
At first glance, it is clear that the main drawback is that at some point we may run out of money and stock prices may continue to fall. In the futures market, this approach is one of the easiest ways to reset an account, if only because of the need to constantly add money to the deposit.
On Forex, this method has no risk limitations at all, since the price theoretically has no limits on value, unlike the stock market, where the value cannot fall below zero.
It is better to use a fixed-cost strategy—this is a management method based on lowering the average price.
The fixed cost method involves the systematic (e.g. monthly) purchase of shares for a certain amount. As a result, we buy relatively little when stock prices are high; when they are low, we buy them too.
How to control the risk level of transactions
First, you need to open a trading account with your free money. This is the amount that the investor can afford to lose without serious consequences for the personal or family budget. At the same time, the amount of money should be sufficient to give the trader the freedom to make trading decisions.
A deposit opened with borrowed money or with the last money of an investor is initially “doomed”. The reason is very simple: in case of loss, the investor will try to get his money back, which means that a well thought out strategy turns into a reckless pursuit with a logically sad result. Hardly anyone wants to face such an outcome in a trading career.
Use stop orders
Second, you need to understand the Stop Loss system. Ignoring stop losses is one of the most common mistakes made by both beginners and experienced traders. Many traders believe that they can “survive” a losing trade and that the price can return to previous levels. In fact, these expectations are often not met and after wasting time and money, the trader closes the position in the red. Or it can be much worse—positions are automatically closed after Stop Out (Margin Call).
There is a simple approach to help you avoid situations like this.
Do not open a position with all your money.
Before opening a position, evaluate not only the potential profit, but also the potential losses. Ideally, this ratio should be 1 to 3 or more. At the same time, the Stop Loss value in the account currency should not exceed 2% of the money in the account. For example, your account has $10,000, which means that on the first trade, the loss amount for an open position should not exceed $200.
The same math applies further: after loss of loss, even if it is $9,800, you have $200 in your account, so the next time the amount of loss should not exceed $4. The probability that all positions will be unprofitable is quite low, and although the trader has a reasonable trading approach and adheres to the above ratio, he is probably “in the black.” It is definitely not difficult.
Stop Loss should in no way be ignored and in no way be increased in hopes of a reversal. Stop orders can and should, however, be changed, but only in those cases where the price is moving in the right direction.
14 tips for traders
You need to move from general information to specific advice and pay attention to what money management mistakes to avoid and what to watch out for. You can use these points as part of your money management strategy.
- Set the maximum loss per transaction. This can be 5% of your total assets. For many newcomers, a lower rate, usually 2%, is more acceptable.
- Do not enter large positions in proportion to the size of your account. You can’t put all your eggs in one basket. Even if you make a profit from a position, you should not increase it at the expense of% of free capital.
- A suitable solution is diversification of the investment portfolio. You should consider the ratio of positions. Because of the proper distribution of positions in the portfolio, you should not be threatened by correlations of lost positions.
- Emotions arising from open positions should not influence your decisions. Euphoria and uncertainty should not lead to irrational decisions. You do not need to open a new position at all costs. If you are unsure whether the current market situation is suitable for you to enter the market according to your strategy, wait for the next clear opportunity.
- Just because you don’t have an open position doesn’t mean you won’t win anything. On the contrary, in this way you avoid losses due to unforeseen (negative) market movements. Being out of position is also a position in a sense.
- Beware of too much activity. Especially in periods when the market is slow and stagnant, traders are often emotional and want to take positions that do not fit their strategy.
- Wait patiently for real trades with high potential for profitability and wisely follow any changes in the market.
- Be aware of the risks and potential profitability of a position before opening it. Make sure you can bear the risk given and whether it is profitable for you to take the risk to make this profit.
- Use stop loss to determine the maximum loss.
- Set the maximum loss per day for the need to suspend trading (for example, 5% of total capital). This action prevents a large loss in one session. Sometimes you just need a break.
- Have sufficient capital. Keep in mind that part of the capital is blocked for long-term positions. Remember the point from the previous list about the size of your open positions.
- Trade less in times of uncertainty (market volatility). This is where less is more. Don’t try to make up for the loss by opening more positions; you’ll lose even more.
- Close losing positions faster and stay winning positions longer than anyone else. Don’t expect the market to reverse in case of losses.
- Make a plan in advance. Make up positive scenarios for him, so you don’t open new positions in euphoria that don’t fit your strategy.
Be disciplined, stick to a pre-established plan. Do not give up on this (do not give up), especially in times of failure. Discipline is one of the most important factors in a trader’s success.
Even with excellent analytical talent and a perfectly working strategy, a trader can lose all the capital if he does not control the risks.
Money management is an investor’s key to gaining stability and professionalism when trading in the market. The fact that most investors do not adhere to a money management strategy makes the use of money management even more important and relevant, because discipline and calculation, even in the most difficult moments of crisis, will help to stay on track or emerge victorious. the general part of the market is considered a loss.