Money management is a concept that protects your trading capital from losing trades and it is the most important skill for trading. This lesson will demonstrate the importance of applying prudent risk management to avoid large losses that can lead to you losing your entire trading account.
Money management preserves your trading capital
Money management, also called risk management, is a core concept that you should start with immediately when you begin to learn and it should be the very core focus throughout your trading career. It will allow you to deal with performance downturns and it will preserve your trading account during these times, enabling you to carry on trading.
The core principle of money management is that you should only ever risk a very small portion of the money that you have to trade with on any single trade.
Many professional traders do not advocate risking any more than 1% to 2% of an account on a single trade.
Limiting your risk per trade to a maximum of 1-2% of your whole account greatly reduces the effect of losing streaks, as you will preserve the majority of your trading account.
Risking only 1% on each trade means you can lose twenty trades in a row and still retain over 80% of your starting capital. If you were to risk 5% per trade, after twenty losing trades there would be less than 40% of your original starting capital left.
The table below shows you the effects of only risking 1% or less on each trade against risking 5%:
After losing twenty trades, the account is reduced to $16,523 after risking only 1% on each trade; risking 5%, the account balance is reduced to $7,547.
After twenty trades, by risking 5% on each trade, the trader now has to make over 100% of the account just to get back to the original starting capital.
Simply by adhering to risk management, an account can survive longer drawdown periods and still be able to trade.
The risk reward ratio ensure that you gain more than you lose
The risk to reward ratio is how much capital a trader is willing to risk in order to gain the potential reward on the trade. You can use either a monetary value or pip value when calculating the risk to reward.
For example, if you are risking $1 to potentially make $2, the reward is divided by the risk and so the risk to reward ratio is 1:2. If you are risking 30 pips on a trade and have a 300 pip profit target, the risk to reward ratio is 1:10.
When looking to take a trade, you should always make sure that your potential reward is larger than your potential loss.
The following chart shows you a real example of how this may look. The chart shows the stop loss, shown as 1, the entry, shown as 2 and the profit target shown as 3.
The distance between the stop loss and entry, shown as 4 is 40.4 pips away. The distance between the entry and the profit target, shown as 5 is 88 pips away. This means that the risk to reward is over 1:2 for this trade.
- Stop loss
- Profit target
- Distance between entry and stop loss is 40.4 pips
- Distance between entry and profit target is 88 pips
Know where your stop loss and profit target is before you trade
Any time you consider entering into a trade, you should not only have pre-determined where your entry will be, you should also have pre-determined where your stop loss and profit target will be.
Once you know where your stop loss and entry point is, you can calculate the risk and potential profit on the trade.
As a general rule of thumb, you should aim for a risk reward ratio of 1:2 or better. If you maintain a risk to reward ratio of 1:2 then you only need one-third of your the trades to win to remain break even.
The risk reward ratio is closely connected to the percentage of your trades that end up winning. The risk reward ratio itself does not automatically mean success. Even a risk reward ratio of 1:4 does not help you if less than 20% of your trades end with a profit. So the risk reward ratio has to be seen as an aspect of an overall trading strategy, and not in isolation.
A great way to improve your effective risk reward ratio is using trailing stops, as they will make sure that in many trades that end of losing, your are losing less than the amount originally set for your stop loss.
So far, you have learned that:
- money management is the most important skill a trader can have.
- using money management will protect your account in the event of a performance downturn and you will keep the ability to trade.
- you should never risk more than 1% to 2% of your account on any single trade.
- by only risking 1%, you can have 20 losing trades in a row and still retain over 80% of your account.
- you should always stick to a risk to reward ratio of at least 1:2 and ideally have a risk to reward ratio of 1:3.
- risk to reward ratio is calculated by dividing your profit target by your stop loss.