Welcome to Money Management! In this video, you will learn what money management is, how to apply money management, and how to calculate stop loss amounts.

Overview

Broadly speaking, money management is the art of limiting the risk of a portfolio while maximizing its return. Money management is the area of your system that will have the greatest impact on the bottom line – your profits. It is so important, that studies have shown that up to 90% of the variance in a trader’s performance can be directly attributed to it. In the absence of a 100% accurate system, money management is an essential element of success. It is not complicated, but it requires a lot of discipline. If you don’t use money management, you could have the best trading system in the world, one that is correct 95% of the time, and still lose money. On the other hand, with good money management practices, you could have a 50% accurate system and still earn great returns.

The Elements of Money Management

The elements of money management are (1) stop loss order for each trade, (2) a specific amount of money to risk in each trade, and (3) a maximum amount of money to risk over a given time period.

So what amount of risk should you be willing to take? We refer to an answer given by a successful trader – "Never risk more than 1 to 3% of your total equity in any one trade”. By risking 1 to 3%, you are indifferent to any individual trade. Keeping your risk small and constant is absolutely critical. While taking more aggressive risks could easily reflect an increase in your account as high as 20% in a day, the swings in your account and potentially your state of mind will be larger. In short, the repercussions of taking aggressive risks may not be worth it. As a rule of thumb – one trade should not matter.

Risk

Just like beauty, risk is in the eye of the beholder. What may be considered risky for one trader may be risk averse for another. Three important factors affecting how you see risk are (1) how much time you have to grow your investments, (2) available capital to invest and future capital needs, and (3) your personality and risk tolerance. Are you the kind of person who is willing to risk some money for the possibility of greater returns? Everyone would like to reap high returns year after year, but if you are unable to sleep at night when your investments take a short-term drop, chances are, the high returns from those kinds of trades are not worth the stress.

There is a fundamental law in trading and investing, or for any business for that matter – the higher the risk, the higher the returns. To succeed in trading, you must accept that the possibility of greater returns comes at the expense of greater risk of losses – the risk reward tradeoff. This does not mean risk is bad. In reality, we don't want to eliminate risk, rather, optimize it for our unique condition and style.

Trader Risk Profile

For example, a young person who won't have to depend on his or her investments for income can afford to take greater risks in the quest for high returns. To understand this, we will show 3 broad groups of traders, but these could be subdivided into many more.

The conservative trader values long term capital preservation more than the growth of returns and accepts low risk for slow and steady growth of returns. The moderate trader values medium term returns equally to capital protection and accepts moderate risk for moderate growth of returns. The aggressive trader values short term returns more than capital protection and accepts high risk for short term extraordinary returns. We can also have the very aggressive trader and many more categories in between.

The amount of risk traders take depends on their risk profile. A conservative trader could risk 0.1% - 1.5% of his capital on any given trade. A moderate trader could risk 1.5% - 3% of his capital on any given trade. An aggressive trader could risk 3% - 5% of his capital on any given trade.

Position Sizing

After deciding how much to risk per trade, you now need to make sure that your position size is appropriate. Position sizing is an essential part of money management. It is the amount of equity invested on a single trade. For example buying one standard lot of EUR/USD would be equivalent of a position size of €100,000. Finding the right balance between your capital and position size is key to money management.

Taking on position sizes larger than your account can handle could make you very vulnerable to a string of losses. On the other hand, if your position sizes are too small, much of your account equity will sit idle, which will hurt your performance. To calculate the correct position size, we have to combine two different things (1) the stop loss level in pips, or in other words, the distance between the entry level and the stop loss level and (2) the amount of money to risk on each trade, expressed as a percentage of equity or an amount. Let’s take a look at a few examples.

Example 1

Let’s say you have a possible double bottom and want to buy the share of Apple, risking $1,000 representing 1% of your capital. The entry level is $150 and the stop loss is at $140. Subtracting $140 from $150, you have a stop loss amount of $10; in other words, 10 dollars per share. Given that our amount to risk is $1,000, then the position size is equal to $1000 divided by $10. This equates to 100 shares, therefore, on this trade, you will go long 100 shares requiring $15,000 as capital.

Example 2

Let’s say you have a possible double top and want to short the stock of Google, risking $2,000 representing 2% of your capital. The entry level is $1,000 and the stop loss is at $1,050. Subtracting $1,000 from $1,050, you have a stop loss amount of $50; in other words, 50 dollars per share. Given that our amount to risk is $2,000, then the position size is equal to $2000 divided by $50. This equates to 40 shares, therefore, on this trade, you will go short 40 shares requiring $40,000 as capital.

Example 3

Going to Forex, say you have a possible double bottom on the EUR/USD and you want to go long, risking $1,000 representing 0.5% of your capital. The entry level is at 1.15 and the stop loss level is at 1.14. Subtracting 1.14 from 1.15, you have a stop loss amount of 0.0100; in other words, 100 pips. Given that our amount to risk is $1,000; then the positions size is equal to $1,000 divided by 0.01. This equates to 100,000 EUR/USD, or 1 standard lot.

Example 4

Let’s say you have a possible double top on GBP/USD and you want to short risking $500 representing 5% of your risk capital. The entry level is at 1.30 and the stop loss is set at 1.3025. Subtracting 1.30 from 1.3025, you have a stop loss amount of 0.0025; in other words, 25 pips. Given that our amount to risk is $500, then the position size is equal to $500 divided by 0.0025. This equates to 125,000 GBP/USD, or 1.25 standard lot.

Recap!

In the next video, we will talk about risk, reward and expectancy. Thank you for watching!