Money Management Rules
Money management — or "risk management" as we prefer — are strategies designed to protect your capital from drawdowns. Capital preservation should be your number one priority.
Drawdowns
A drawdown is caused by a string of consecutive losses. Drawdowns are expensive, not only in terms of capital, but also erode your confidence. Traders who incur severe drawdowns often suffer from burnout that inhibits their ability to continue trading.
Six Basic Rules of Money Management
No matter how skilled you are as a trader, there is always an element of uncertainty. Failure to apply proper money management is bound to harm not only your capital but your health. It's not worth it.
Six basic rules:
- Never risk capital that you cannot afford to lose;
- Use stop losses to limit risk;
- Stick to your position size;
- Know your risk-reward ratio and expected success rate;
- Consider sector and market risk; and
- Never deviate from your trading plan.
Never Risk Capital that you Cannot Afford to Lose
Calculate the maximum amount of capital that you can comfortably afford to lose — in a worst case scenario — and never risk more than that amount at any one time.
Capital at risk is determined by your stop loss and position size.
Stop Loss Orders
Stop loss orders are not ironclad risk management tools — prices sometimes gap down or market depth may not be sufficient to cover a sudden surge in sell orders — but they help to limit your maximum loss per trade.
Position Size
Your position size determines the amount of capital at risk on each trade. Capital at risk is calculated by multiplying the stop loss percentage (your stop loss as a percentage of the entry price) and the amount of capital allocated to a trade.
Use the 2% Rule as a standard rule-of-thumb for calculating position size with equity trades.
Position size should be based on your expected risk-reward and success rate. Trading strategies with a low success rate are more susceptible to drawdowns, even if they enjoy a far higher risk-reward ratio. Adjust the 2% Rule downwards if your expected success rate is below 50%: to not more than 1% of capital at risk on each trade.
Risk-reward & Success Rate
Know how much you expect to make on each winning trade and how many winning trades (out of 10) you expect to have. Adjust the 2% Rule accordingly.
Know when to quit if your planned risk-reward and success rate fail to materialize.
Sector and Market Risk
In the real world, we do not trade with a perfect binomial distribution. The biggest flaw in most risk management systems is that stock movements are not always independent — they tend to rise and fall together.
Adapt your trading plan to limit exposure per sector and to the overall market, at any one time.
Stick to your Trading Plan
Write down your trading plan and stick to it. Religiously. Without hesitation.
If your plan isn't working, stop trading and re-group. Don't make changes on the fly.
Summary
Never risk capital that you cannot afford to lose. Stick to your position size, to protect both your capital and your health. Adapt the 2% Rule to your trading style and expected success rate. Allow for sector and market risk, where stocks may rise and fall together. Execute your trading plan religiously — without hesitation — and never deviate from it.