Money Management techniques in trading
In addition to the risk per trade, it is necessary to have a maximum risk for the total account. This maximum risk would be the percentage you would be willing to lose in total, assuming that all your open trades end up losing. If you are a swing trader you could take this as the maximum risk per month. If you are a scalper or day trader, you might take this risk per week or fortnight. Depending on your trading style and your risk aversion.
For example, if your maximum risk is 5% of your account and you have $10,000, you can take $500 as a loss (weekly or monthly, you set your rules, percentages, risk and money).
If you happen to lose that amount, the best thing to do is to stop, analyse what happened (maybe you had a bad week, were under stress, or slept badly) and take a few days off until the deadline you set for yourself has passed. Even if this happens to you on the live account, you can go back to the demo account for a while. By doing this, you will manage not to lose all the money in your account, look at the market from the outside and analyse where you have failed to reflect on it.
It should be added that leverage plays an important role with regard to account risk. Depending on the trading style the risk percentage should be different.
If you focus on cash equities and long term, you probably don’t use financial derivatives and need to outlay more money, so you won’t have as many open positions. But in styles such as day trading or swing trading it is more common to use CFDs, futures or options contracts, which do not require large sums of money, allowing you to open more trades.
Brokers allow very high leverage. If you have a small account and leverage yourself too much, nerves can lead to ruin by making you make mistakes such as moving the stop, buying more contracts, opening more trades, etc. Try to only risk the precise amount of money you calculated for each trade with a leverage that works for you and not one that puts your account at risk. Risking too much money on a single trade is a fatal mistake and so is misusing leverage.
So, can you take advantage of leverage and avoid risk? Yes, of course you can. Risk management is essential when trading with leverage if you want to avoid losses you cannot afford, but you need to be clear about a few concepts:
- Invested capital: total amount of money in the trade.
- Risk capital: amount of money in the account that can be put at risk in the transaction.
- Stop loss: serves to limit the capital at risk.
Let’s look at an example to make it easier to understand:
You buy 100 shares of company X at u$s20 each, so your invested capital is u$s2000. But you are not necessarily risking u$s2000, because if you place a stop loss at the u$s17 price level then you are only risking u$s3 per share. Therefore, the capital risked is $300 ($3 risk per 100 shares).
This shows us that we can choose, based on the capital at risk, the capital invested that would be appropriate. However, this is not always possible. For example, by risking very little per share, your management may allow you to buy more shares. But the disadvantage is that the capital to be invested would be very large. Let’s look at it in numbers:
Assuming that the risk capital is u$s300 according to your management, you buy shares of company Z at u$s50 setting a stop loss at u$s49,85. The risk per share is $0.15. So, given these numbers you can buy 2000 shares since 300/0.15=2000. But 2000 shares x u$s50 each gives us a total of u$s 100000. This implies that the capital at risk would be u$s 300 but the capital to invest would be u$s 100000. You can assume the risk because of your management but the question is: do you have u$s 100000? Let’s assume you don’t.
This is where leverage comes in, as you could move those 2000 shares but without investing $100,000, but by buying for example 2000 CFDs of that company. Assuming that the broker asks you for 5% of the nominal you should invest u$s 5000. If you win, you win as if you moved u$s 100000 and if you lose, you lose as if you moved u$s 100000, which is the u$s 300 that you had calculated before. Therefore, the risk is under control.
We will make a clarification with respect to the example: if your account is u$s 10.000 it would be crazy to put u$s 5.000 in a single operation. We will show the example of what this calculation would look like with the following assumptions, using the anti-martingale:
Total capital: $10,000
% loss per trade (capital at risk): 2% of total capital, which would be u$s200
% of capital in 1 trade (invested capital): 10% of total capital, which would give u$s1000.
In this case, if the trader makes 1 trade he would put u$s1000 with a risk of u$s200 (where the stop loss would go), protecting the rest of his capital and every time he finishes a trade, he opens another one.
If you want to have several operations at the same time, you know that you can not do more than 10. Of course this is utopian, since it would be rare that a trader would place 10 operations of u$s1000 when his capital is u$s10000. Never do that, you must go little by little. You can have several trades at the same time, but never invest the total of your capital. The amount of open trades at a time is up to you, but always keep a good percentage of your capital, because if those trades are all losing (drawdown), you will still have money available to make new trades and recover your losses. In the example, 3 trades at a time would be reasonable.