Money Management

As you have seen, there is emotion involved in investing, and it can never be totally eliminated. However, it is also true that the more experience and practice you get with small trading aspects, the more you will be able to reduce emotionality. But there is only one way to truly minimise your feelings, and this is money management.

Money management is the process of sound financial management that involves investments, budgets, taxes and banking services. It is divided into:

Risk Management analyses the potential risks of the invested capital, depending on the position on its position in the market.

Position Sizing identifies the capital to be invested in each trade and the allocation of the various asset classes, the so-called Asset Allocation.

Risk Management

It is the process by which you measure or estimate risks and then subsequently develop strategies to manage them. The main function of risk management is to maximise profits, trying to reduce the risk of losses.

A trader is, first and foremost, a risk manager and, as such, his primary goals are to not lose money and to ensure a stable income. Alexander Elder said: “to help ensure success, practise defensive money management. A good trader watches his capital as carefully as a professional scuba diver watches his air supply.”

Risk management is undoubtedly one of the keys to success in trading, but ironically, it is also one of the most neglected aspects. It becomes indispensable when you decide to invest a certain amount of money, or, in other words, when you expose yourself to financial risk.

You should always remember that trading has to be a business programmed to make money over time. Only by knowing how to assess the risks and build a lasting strategy can you effectively contribute to keeping your business profitable. Risk management is fundamental in trading because, even before you open a trade, you need to establish how much you are willing to risk in that trade. That is the first rule for surviving in the long run.

Why do you trade? Because you have decided to make money, the first fundamental rule is to build a strategy focused mainly on defending your investment so that you can protect your money. As Warren Buffet said: “Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”

Many traders are overwhelmed by the anxiety of making a profit; they do not at all value the size of their accounts and their exposure on the market (position sizing). They merely calculate how much they are willing to lose, and transmit the order on the platform, exactly as it happens on gambling websites (which is very different to trading).

By doing this, traders do not look at the long-term return of their invested capital, rather, they are simply trying for the “Jackpot,” which can immediately lead to “big winnings.” Not adopting a careful risk management strategy, on the contrary, is the easiest way to make sure that your losses will soon overcome your profits, and, little by little, reduce your trading account to zero.

No analysis will be 100% certain, and your portfolio is at constant risk. So, the application of risk management rules seems to be the only way not to sink. Risk management allows you to set aside your feelings and apply your reason to what the purpose of trading really is: earning money.

Position Sizing

None of us is the same, either as people or as traders. Everyone has different feelings and emotions; some people are more aggressive whereas others are more cautious. Risk Management is the most important aspect of the trading process. The first step is determining how much of your capital you are willing to risk when you open a trade, according to your risk tolerance.

Risk tolerance is something subjective, so you will gradually learn what kind of approach you want to follow. It is evident, however, that if you are particularly aggressive from an early stage, that emotions will be even harder for you to handle because you have little experience. When something goes against you, it will have an even more significant impact, complicating things.

My advice, therefore, is to take a quieter approach and then, gradually, behave more or less aggressively based on how a particular situation is going.

Therefore, it is always good to start with small things. When you make a little investment, there is a bit of emotion involved, but if you risk a small amount of money, you will be less emotionally involved than with a large-scale investment. Starting with small trades means handling positions with less stress.

Try to create a balanced profile, starting with a modest investment aimed at protecting your capital, with average risks and returns. Being different people (and traders), we also have different approaches: some of us are more aggressive while others are more conservative. You have to use the risk appetite that best suits you.

For example, I prefer quieter and stress-free trades, with many small profits but constant in the long run. By trading like this, I also reduce all the negative factors and emotions that I treated in the previous chapters.

If you sat in front of a computer knowing that you could lose hundreds or thousands of dollars every day, you would trade with much more tension. If, on the other hand, you know that the percentage of potential loss remains limited, your fears will also be limited.

Money Management makes you a profitable trader

Trading is leaps and bounds above gambling when it comes to probability and risk. Trading is not gambling because it does not create risk out of thin air like casino games. Trading risk is already there because it is part of doing business, the buying and selling of goods, much like bartering. The smarter you are about making deals, the better your odds of success will be.

Trading requires that you examine the market carefully to determine whether an asset is being priced too low or too high, to then act accordingly in order to make a profit. This is similar to going to an auction and buying a house you believe is big enough to sell at a higher price, for a profit. If you are right, you win. If you are wrong, you lose. The amount you win or lose depends on your timing and the amount you were willing to risk.

Money management is extremely important when it comes to being successful at trading. With good money management, you can afford to be off on your estimate and still be successful in the long-run. You can make some bad decisions and yet the good decisions you make will make up for it, by a lot more. It all comes down to how you manage your risks and your money.

Having a good market timing approach allows you to increase your probability of successful trades. However, there will be losses with any method. Therefore, good risk and money management are essential if you want to walk away from the table with a profit at the end of the day.

With money management, you need to first determine the amount of money you have available for trading. Then, you need to recognise that there will be draw-downs from time to time. You must treat trading as a business, where there will be expenses. The amount of capital you have for trading will determine the time-frame and the vehicle you can trade.

For example, if you start with a small amount of capital or trading, you have to consider trading costs that would incur from frequent trading such as day-trading, as opposed to fewer costs for position trading. On the other hand, position trading would require bigger risk exposure per trade as opposed to day-trading from minute charts.

The other thing you must consider is the amount of your capital that you are willing to risk per trade. This should be a percentage, and absolutely no more than 10% but preferably much less than that, around 1-3% is a lot more suitable.

If your account is small, 1-3% or even 10% May limit you to trading only in certain markets. This means that you either have to first save up more capital before trading more widely, or you would have to find a trading activity that would enable you to trade your small account following the suggested money management risk percentages. This might mean looking at trading Options or Forex where mini-sized positions can be taken.

By having the discipline to stick to risk no more than a small percentage per trade, you can afford to have a string of losses and still come out profitable in the end.

Following a strict money management plan requires strict use of the stop-loss. You can be sure that the stop-loss will get you out of your trade within your allowable risk-amount per trade. Never change your stop-loss to allow for greater risk or losses. Be sure to never let a profit turn into a loss, getting your stop-loss to break-even when profit has reached a certain level, for example, after an initial risk.

If you spend some time learning about money management and have the discipline to apply it, you will be profitable trading any market with virtually any system, although the better the system, the better your results.

As I said, with Position Sizing, you can even decide the allocation of your money on the various asset classes, the so-called Asset Allocation.