What does Money Management mean?
Money management means money management. It consists of recording all movements related to the budget we have. More specifically, in trading, it consists of finding the right formula to best manage the capital prepared for the investment. The ultimate goal is to maximize profits and minimize losses.
There is no "magic" formula to determine the money management suitable for your trading activity. There are, however, gods parameters to consider when creating one tailored.
These are some of the parameters:
- the capital: that is, the sum of money you have dedicated to your trading activity. Regardless of the amount, you must be aware that you can also lose it. So, trade with money you can afford to lose, safe in the knowledge that that loss will not compromise your lifestyle and financial stability.
- financial instruments: the choice of financial instruments is very important. Not all assets are accessible to all investment capital. Therefore, before choosing which assets to trade we recommend checking the spread, the margin required, the available leverage, the volatility of the individual product, the liquidity of that market, etc.
- operation: you need to evaluate what type of operation you want to adopt. You can choose between intraday, multiday, position trading operations... Based on the type of operation you will be able to evaluate how many operations you will carry out and how to arrange the percentage of capital you want to risk at a daily, weekly or monthly level.
- strategy: Money management should also be formulated based on the strategy you apply in trading. This is because a money management formula cannot be suitable for every type of strategy and vice versa.
➡️ Pros & Cons of Money Management
Money management has several pros and few cons. Let's see together what they are:
To put it briefly we could say that Money Management concerns the allocation and management of one's capital, but there is more.
The activities that fall into this field are essentially 4:
- Setting market orders
- The risk-reward ratio
- Portfolio formation: diversification
- Mental state management.
In summary, if the analysis phase tells us which assets to buy and the timing tells us when to buy, money management tells us how much capital to invest.
Some experts think that money management is the most important factor in trading. It is partly true, because it represents one of the secrets of Trading, without which it is impossible achieve success in the long run.
But in reality there is more. If you could speak frankly to an experienced trader, he will confess that the success of his strategies and his capital management always comes after the health of his mental state.
In fact, i factors that influence trading results I am:
- Strategies: 15%
- Money Management: 30%
- Mental state: 55%
➡️ Money Management – Stop Loss & Take Profit
Stop loss and take profit they are trade orders. Traders use these orders to reduce losses and maintain profits.
Stops and takes are similar as, in both cases, the trader determines the prices in advance, upon reaching which the system will automatically execute these orders. That is, both stop loss and take profit are pending orders.
Stop loss and take profit are the main elements of a risk management or money management system.
Stop Loss
Stop loss is an order you give to a broker to sell or buy an asset if its price starts to change sharply against you and you want minimize your loss as much as possible. For example, if you buy an asset at a price of 100, you could set the Stop Loss at 95, so that if there was a drop in value you would not lose more than 5%.
But be careful do not place the Stop Loss too close to the purchase price as you may face the risk of exiting the market at the slightest price fluctuation. This can often happen before the price starts to rise and the trade can become profitable.
Take Profit
As regards the Take Profit, however, it is an order that you give to the broker to close your position on an asset when his price reaches a level that is satisfactory to you.
For example, you purchased an asset at a value of 100 and you want to sell it when the price increases by 10%, you can set the take profit to 110. When the price of the asset reaches the value you indicated you will automatically exit the market with your I earn.
The importance of orders
Remember that It is very important to set both Stop Loss and Take Profit. If you are a beginner and carry out online trading operations using financial leverage, it is essential to set a Stop Loss for good money management.
If you didn't do this you would have to follow the market trend without ever getting distracted, to exit at the right time. The stop loss can be a guarantee that allows you, in the worst case scenario, to limit your losses.
➡️ Money Management – Risk/return ratio
When deciding to trade online in any financial market, the trader faces certain risks to receive rewards.
Basically, the calculation of the risk/reward ratio determines the amount of money you are willing to risk to make a certain profit on a particular trade.
“It doesn't matter if you're right or wrong. What really matters is how much you gain when you are right and how much you lose when your predictions are wrong.”
George Soros
Most traders are so concerned with finding a profitable trading strategy that they often forget the importance of the risk-reward ratio. In reality it is essential when deciding to operate on the financial markets to consider this relationship.
Finding the right balance
The key to being successful as a trader is finding the ideal balance between the risk of the trade and the profit that can be obtained. Furthermore, this balance should be realistic and consistent with your trading strategy.
For example, let's say you decide to set a profit target three times the stop loss entered, a risk/reward ratio of 1:3. What happens if your strategy fails to deliver this long-term risk-reward ratio? In this case, you will end up losing money.
On the other hand, if your trading strategy is capable of making you trade with a risk/reward ratio of 1:5, but you usually close the trade when your profit only reaches double your stop loss, you always leave money in the market.
| Risk/Reward Ratio | 20% | 30% | 40% | 50% | 60% |
|---|---|---|---|---|---|
| 1:1 | Not Profitable | Not Profitable | Not Profitable | On par | Profitable |
| 1:2 | Not Profitable | Not Profitable | Profitable | Profitable | Profitable |
| 1:3 | Not Profitable | Profitable | Profitable | Profitable | Profitable |
| 1:4 | On par | Profitable | Profitable | Profitable | Profitable |
| 1:5 | Profitable | Profitable | Profitable | Profitable | Profitable |
In this table we see how by adopting a risk/return ratio of 1:2, investments are profitable if it is possible to win at least 40% of operations. With a ratio of 1:4 it is enough to guess at least the 30% of the investments.
So, you should spend a lot of time on test your strategy and try to determine a realistic average profit that your trading strategy brings on each trade, also in relation to the stop loss and take profit levels you choose.
Risk/return example
There formula to calculate the risk/reward ratio it's relatively simple. If you risk 50 pips on a trade and set a profit target of 100 pips, your actual risk/reward ratio for the trade will be 1:2.
In online trading it is also necessary take the spread into consideration charged by your broker in order to effectively analyze risks and rewards. If you don't pay attention to the spread, you will end up using a risk/reward ratio that is not accurate.
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