We'll start from the definition. Money management is the way to decide which part of account can be under the risk in a certain trading transaction.
Decision making makes 50% of trading and these decisions are about the time when to enter the market. Another 50% refer to when to leave the market. How do you think which of two decisions has a primary importance? Of course, the second one. Exactly this type of decisions determine your performance. That is how "money management" started to be developed. Efficient money management for trading allows traders to "survive" in the market. Only ensuring an equal proportion between profit and loss, a trader has an opportunity to deal with money resource but not to play.
There are several principles of money management. Let’s consider some of them as applied to trading:
- Total funds (margin) invested in a transaction shouldn't exceed 10-15% of total capital . In this case, a trader is protected from excessive investment, which can lead to collapse.
- Risk rate for each market invested by a trader shouldn't exceed 5% of his/her capital. Thereby, if transaction is unprofitable trader will lose less than 5% of his/her total amount of money (this recommendation is for big capitals).
- Markets united into one group move more or less equally. Making trades in each group breaks the principle of diversity. Therefore, investment to similar markets should be conducted carefully. You should always consider the rule of the best possible rate of investment. Anyway, it should be diversified to a certain extent. You should invest your capital so that loss received on one large transaction won't put you out of business. But as far as possible, these losses should be compensated by profits from other transactions. There are four major markets in the Forex market: US Dollar, Pound of sterling, Yen, Euro zones. Their exchange rates are similar.
- Determination of probable profit-and-loss rate
- Rate of profit is determined for each potential transaction. Then this profit rate should be balanced with potential loss in case the market moves in undesirable direction. Generally, preferable proportion is 3:1. If it's different, you'd better not to enter the market. For example, if risk is 100$, the potential profit approximately should be 300$. Since substantial gain can be attained due to a limited number of trades, it should be maximized by keeping profitable positions as long as possible. On the other part, loss must be minimized in case of failure.
- Trade with several positions
- Entering market with several contracts (ie, more than one lot),a trader should divide them into so-called trending and trading positions.
- Trending positions are made with free stop loss orders, which allows to divide these positions even on consolidation and correction. These positions grant a trader with the opportunity to get maximum profit.
- Trading positions are supposed to be used in short-term periods of trade and limited with quite strict stop loss orders. Therewith, when certain price is reached, they are closed and restored during the resumption of the tendency.
- Conservative and aggressive approaches
- aggressive approach implies great risks and at the same time great profit. But you should understand that aggressive strategy assumes that rates exceeding half of the deposit will bring a trader profit till he correctly predicts the trend. And a simple error can lead to great losses. On long-term periods this method can be applied only by professionals .
- under conservative approach,trader goes to his goal slowly, step by step. He risks the less part of his deposit, but earns not much too. Some time later his/her deposit can be doubled. This method is good for beginners and it is applied for long-term periods.
- It is for sure that a trader will be anyway successful if he correctly forecasts the market movement no matter what approach is selected.
- Open rules: a) open only if you have one main and several extra signals; b) prior to opening, write down the enter price, the close price, the price under which unprofitable position is closed and expected "lifetime" of the position.
- Rules of support of trades and partial close of trades prior to settlement time:
- keep the position only if analysis proves your conclusions;
- close partly if your losses are more than expected;
- wait if your losses are less than you expected, if the price stays at the same level, if the price doesn’t reach the point of calculated profit.
- Close rules:
- when the estimated time is over;
- hen you get expected profit;
- when you get expected losses;
- when you get the maximum profit.
The market is extremely diverse and principles of money management alter over the time. The main point for traders is that a trader changes them, not the market.
Try to put Money Management Stop in practice.