3 Keys to Money Management

Contributed By Rakesh

There are 3 Key elements to good trading money management:

1. Trading Capital

For every winner in trading there is a loser, this being so, you should consider trading as a battle and to fight the battle you need ammunition. Your trading capital is the most important part of your trading, if you run out of it the trading is over. You should keep your trading capital completely separate from living expenses, don’t trade with the borrowed money. Only trade with money you can afford to lose .

It is much harder to make money when you have to, if you cannot afford to lose it, this will only add pressure to your trading and you will make errors.

The preservation of capital is of the utmost importance.

2. Win/Lose Ratio

To manage your trading properly it is absolutely necessary to document each and every one of your trades. If you don’t and you are losing you will not know where and why you are losing and what you need to do to make things profitable.You will become good trader if you make sure the mistakes are not repeated again and again.

Nobody wins all of the time, the win/lose ratio is usually expressed as a percentage (e.g. if you win 66 trades out of every 100 then you will have a win% of 66% and a losing% of 34%. This expressed as a ratio is 66/34 = 1.941:1.) You do not have to make 100 trades to calculate this; all that you need to know is the number of winning trades and the total number of trades made.

  • For example you have made 37 trades in total and you have won on 21 occasions, therefore you must have 16 losers (37-21). The win/lose ratio is 21/16 = 1.3125:1, the win% is 21/37 = 56.76%. The losing% is 16/37 = 43.24%.

It is quite possible to make a profit even if you have more losing trade than winning trades and many swing trading methods work on this principle having say 20 wins to 40 losers = 20/40 = 0.5:1 ratio. Anything less than 1:1 or 50% win% and you will have more losers than winners. Many traders have a problem trading a system with a low percentage of winning trades, even though it wins in the long run psychologically they would find a long run of losers very difficult to cope with.

3. Risk/Reward Ratio

There are many ways to make money in the stock market, it depends on your trading style, no “one” method is right for everyone. Many traders say that they only trade with a 3:1 risk/reward ratio (i.e. they are going to risk 1 and attempt to win 3.)

  • Calculating reward is simple it is just the average number of points won per trade, so if you have made 37 trades, of which 21 won a total of 252 points your average win (reward) is 252/21 = 12 points. Risk is just the average number of points lost, over the same 37 trades you must have had 16 losers and had a total loss of 128 points your average loss (risk) per trade is 128/16 = 8 points. The risk/reward ratio is simply 8:12 or 1:1.5.

Combining the trading money management keys 2 and 3 together, we can calculate how much we can expect to make for every trade on average over the long term. If you end up with a plus figure you will be winning and making profits, should you end up with a minus figure you will be losing.

You may say that you do not need to do any calculations to see if you are losing, you already know this because your account balance is down. The points of this exercise is that if you do the two calculations above you will find out where you are going wrong, and by playing around with the expectancy calculations below you do various “what if” scenarios to see what can be done to make things better.

This also applies to profitable trading; there is always scope for improvement.

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