What is money management?
Mastering trading and succeeding in the long run depends on various factors such as strategies, more or less advanced techniques, a trader’s own experience and approach on stock markets, personal qualities, etc.
Risk and capital management is also one of the keys to successful trading. Money management, as we call it, is the determining factor for high-performance trading and here is why.
The difference between money and risk management
Money management is considered to be a subcategory of risk management. Risk management includes: market risk, liquidity risk, counterparty risk… Profit/loss management, hands on management of one’s trading account and of the volumes involved are all part of money management. The focus is on the inside rather than the outside. Money management is introspection. It is the management of capital, stops and efficiency objectives.
It is important to bear in mind that it is the primary source of positive performance in the long run. No matter what techniques or strategies are used, not managing the account properly is a slippery slope that leads to financial loss. This is why a trading system itself is of little value if a trader is incapable of managing their own money.
The ingredients for good money management
It is all a matter of performance in relation to the risk taken. The aim is to take the least amount of risk possible and maximise profits. In this respect, the profit/loss ratio is the main focus, and it entails good management of the portion of capital that is involved as well as good stop-loss and limit placement. This will also require a reasonable use of the leverage effect. It is easy to understand how dangerous it is to take on a position that exceeds ten or fifty times one’s actual capacity. Volume management is an essential element of trading.
Market volatility is a common phrase. In money management, changes in balance and profits are the issue at hand. The volatility of the trading account must be examined. Going from +£500 to -£750 in just a few hours is problematic, especially when the base capital is equal to or below £5,000. This represents a £1,250 variation, or 25% of a £5,000 account. A massive loss! Everything is relative, since this would only represent a 2.5% change on a £50,000 account. I like to use this infinitely small trade move (in terms of volume) as an example: in this case, the risk of loss is minimal…
Although all of these principles are fairly easy to understand, their implementation is much trickier. The heat of the moment, vagaries of the markets and fluctuations that are always unexpected create a daily atmosphere where money management is a constant challenge. The psychological aspect then comes into play and it sometimes gets difficult to stick to theory. Emotions and frustration are the ultimate weapons for self-destruction. “The market is always right” is a widespread expression that is entirely relevant here, in the sense that one must be humble before the market and leave one’s ego aside. By having precise money management parameters, a trader can keep a cool head and hope to make progress without too much stress.
Too much caution kills the essence of trading
There must be no confusion between money management, caution and risk-taking. Risk is a strong component of trading, it cannot be bypassed. Reducing the amount of risk to zero would mean not trading at all.
Good money management is precisely what helps optimise the risks taken and avoid making foolish moves while achieving respectable performances. It is important to be careful but only up to a certain point. Taking measured risks by finding the right balance: that is the art of trading.
In a way, money management can be considered the bedrock of performant trade practices. Each individual can develop their own approach and habits, but it all comes down to losing as little as possible and preserving capital. And if all goes well, earnings should come pouring in soon enough!
Last Update on 22/01/19