Money Management – Dismissing Risks Is Suicidal
If you do not master the concepts of money management quickly, then you will discover that margin calls will be one of your biggest problems trading. You will find that these distressful events must be avoided as a top priority because they can completely wipe out your account balance.
Margin calls occur when price advances so far against your open trading positions that you no longer have sufficient funds left to support your open positions. Such events usually follow after traders begin to over-trade by utilizing too much leverage.
Should you experience such catastrophes, then you will have to endure the pain involved in completely re-building your account balance back from scratch. You will find that this is a distressful experience because, after such events, it is normal to feel totally demoralized.
This is the exact situation that many novices end up in time and time again. They scan charts and then think that by doing so they can make quality decisions. Next they execute trades but without giving a single thought to the risk exposures involved. They do not even bother to calculate any protection for their open positions by deploying well-determined stop-losses. Very soon, they experience margin calls because they do not have sufficient equity to support their open positions. Large financial losses follow as a consequence which are sometimes so big that they completely wipe out the trader’s account balance.
Margin trading is a very powerful technique because it enables you to utilize leverage to activate trades of substantial worth by utilizing just a small deposit. For instance, if your broker supplies you with a leverage of 50 to 1, then you could open a $50,000 position with just a deposit of $1,000.
This sounds great but you must understand that there are significant risks involved when using leverage should price move against your open positions. In the worst case, a margin call could be produced resulting in all your open trades being automatically closed. How can you avoid such calamities?
To do so, you need to develop sound and well-tested risk and money management strategies that will guarantee that you will never overtrade by restricting your risk per trade within well-determined limits. You must also master your emotions such as greed that can make you generate poor trading decisions. It’s easy to fall into this trap because the enormous daily market turnover can seduce you into making unsubstantiated large gambles.
Understand that the market has a very dynamic nature that can generate levels of extreme volatility that are significantly larger than those produced by other asset classes. You must never underestimate this combination of high leverage and volatility because it can easily cause you to overtrade with devastating results.
Basically, a money management strategy is a statistical tool that helps control the risk exposure and profit potential of every trade activated. Money Management is one of the most important aspects of active trading and its successful deployment is a major skill that separates experts from beginners.
One of the best money management methods is the Fixed Risk Ratio which states that traders must never risk more than 2% of their account on any single instrument. In addition, traders must never risk more than 10% of their accounts on multiple trading.
By using this method, traders can gradually increase the size of their trades, while they are winning, allowing for geometric growth or profit compounding of their accounts. Conversely, traders can decrease the size of their trades, when losing, and thus protecting their budgets by minimizing their risks.
Money Management, combined with the following concept, makes it very amenable for beginners because it enables them to advance their trading knowledge in small increments of risk with maximum account protection. The important concept is ‘do not risk too much of your balance at any one time‘.
For example, there is a big difference between risking 2% and 10% of the total account per trade. Ten trades, risking only 2% of the balance per trade, would lose only 17% of the total account if all were losses. Under the same conditions, 10% risked would result in losses exceeding 65%. Clearly, the first case provides much more account protection resulting in an improved length of survival.
The Fixed Risk Ratio strategy is preferred to the Fixed Money one (e.g. always risk $1,000 per trade). The second has the inherent problem that although profits can grow arithmetically, each withdrawal from the account puts the system a fixed number of profitable trades back in time. Even a trading system with positive, but still only mediocre, profit expectancy can be turned into a money machine with the right money management techniques.
Money management is a study that mainly determines how much can be spent on each trade with minimum risk. For instance, if too much money is risked on a single trade then the size of a potential loss could be so great as to prevent users realizing the full benefit of their trading systems’ positive profit expectancy over the long haul.
Traders, who constantly over-expose their budgets by risking too much per trade, are really demonstrating a lack of confidence in their trading strategies. Instead, if they used the Fixed Risk Ratio money management strategy combined with the principles of their strategies, then they would risk only small percentages of their budgets per trade resulting in increased chances of profit compounding.
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