Money & Risk Management
If we want to survive as traders it is absolutely imperative that we manage our capital with extreme efficiency. By saying “absolutely imperative” we don’t exaggerate. This parameter of trading is literally a matter of – financial at least – life and death. It has been found in various surveys that this characteristic – that is, the excellent money & risk management – is the most important difference between profitable and losing traders.
It’s important to realize that trading is a game of probabilities. No trader can be right all the time and even the best trading systems have loses. Whereas we cannot control the markets and how they fluctuate, about the only thing we can control is the amount of capital we can lose in any particular trade.
The first step in this direction is to limit our losses. As the old saying goes “take care of your losses and the profits will take care of themselves”. At this point we must stress out that no trading system will be complete without a money & risk management strategy that will fit well with the overall strategy and our profit objectives.
An essential part of money & risk management is to estimate our exposure to the risks inherent in an investment instrument, so that we can limit our losses to an “acceptable” level. If, for example, we trade stocks, money & risk management will help us calculate how many stocks we must buy, in relation to our total capital, so that the risk we take is more or less predetermined.
One of the most important rules of money & risk management is never to risk more than a small percentage of our capital for each trade. The more our capitalization the less percentage we must risk. So, if our trading account is very big we should not risk more than 1% of our capital for each trade. For medium and small accounts this percentage could be 2% and 3% respectively. Trading systems that risk more than 3% of the capital to each trade can harm seriously our financial health.
We’ll explain now in more detail how we actually work out these percentages. Let’s suppose that we have 100.000€ and we decide to use the 2% rule of money and risk management. This means that for each trade we commit to limit our losses to 100.000€*2% = 2.000€. That is, whenever we find ourselves losing 2.000€ we must exit the trade immediately.
Let’s suppose now that we want to buy a stock at 30€. The next step we must take is to decide at what price to sell this stock, should the trade go against us. Let’s suppose that we decide to sell if the stock falls below 28€. Therefore, in this case, we will lose 2€ (30€ - 28€) for each stock we buy. Given that we have decided that our losses will be no more than 2.000€, then we should buy 2.000€/2€ = 1.000 stocks.
From the example above it is obvious that there are two important parameters in money & risk management. The first parameter is the percentage of capital we are willing to risk in each trade. We’ll have to choose this percentage before we trade and it’s usually fixed. Here we’ll have to realize that, while this percentage is constant, the amount of money we risk is a function of the capital we have at any moment. That is, if we make profits and our capital goes up to 120.000€, our risk will be 2.400€ (120.000€*2% = 2.400€). If, on the other hand, we lose money and our capital goes down to 80.000€, then the risk will be 1.600€ (80.000€*2% = 1.600€). This inherent feature of money & risk management, that is the money we risk follows the capital available at any time, has been proved valuable.
The second parameter is the way we calculate our stop loss, that is, the price we will exit the trade if the stock moves against us. The dilemma here is: If we choose a stop loss too far away from the price we bought, the loss will be too big. If, on the other hand, the stop loss is too close, then we will not give the opportunity to the price to “take a breath”. As usual, we will have to find a price in between.
Most novice traders usually set a too narrow stop loss, as they believe that this will protect them from a big loss. This logic, however, usually has the opposite results, as the trade has not given the opportunity to develop into what could have been a profitable trade.
It’s very important to calculate our stop loss before we trade. It’s even more important to sell the security with no second thoughts and as soon as its price reaches this stop loss. If we calculate the stop loss correctly, it has been proved that the first loss is the smallest loss. Our stop loss can act as a safety net for an acrobat. It will protect our capital, if and when something goes wrong.
Another important parameter of Money & Risk Management is to total amount we invest in a particular security. It’s advisable to set a limit in the capital we invest in a particular security. Investors and traders with small capital can invest up to 25% of their capital to trade a particular security. The bigger our capital the smaller this proportion should be. The majority of bigger traders and investors don’t invest more than 10% or even 5% of their capital for each security they trade. This proportion can fall as low as 1% for the big investment and wealth management firms. Of course, this proportion is directly related to the diversification we wish to have in our portfolio.
Let’s give an example, to make things a bit clearer. Suppose our capital is $100000 and we have decided to risk 2% of our capital for each trade. Therefore, our risk will be $2000 (100000*2% = 2000). In addition to that, we don’t want to invest more than 25% of our capital to any security. With these parameters in mind, we want to buy a stock at $50, with a stop loss at $48. So, our risk per share will be $2 ($50-$48) and therefore we can buy 1000 shares risk ($2000/$2). These shares, however, cost $50000 (1000 shares x $50), which represents 50% of our capital, more than our limit, which is 25%. This will mean that we will buy only 500 shares, because 500*50 = 25000, which is 25% of our capital and our limit.
Finally, let’s suppose that our stock starts moving in the direction that we wanted and starts becoming profitable. As this movement in our favor will not last forever and the trend will reverse sooner or later, we will have to give an answer to the following question: When should we sell? The more experienced traders and investors insist that this is the hardest part of trading. Her we must use a trailing stop, which follows the price movement and will give us the signal when to sell.
Just as the stop loss, our trailing stop should not follow the price too closely or too loosely. It’s important to find a reasonable solution that will catch as much of the profit as possible and at the same time to leave the security room to move.
Here, too, we must learn to employ our self-discipline and sell the security with no second thoughts and as soon as it reaches our trailing stops. We can imagine our stop loss and trailing stop as red traffic lights. It’s not very clever to ignore them! Even if we ignore them once or twice with no consequences, it’s very doubtful and we will reach our destination safely by ignoring them all the time.
We cannot overestimate the importance of correct Money & Risk Management. This is what makes the difference between success and profits on the one hand and failure and financial devastation on the other. To sum up, there are five parameters in Money & Risk Management:
We decide beforehand the proportion of our capital we are going to risk. This proportion should not be more than 3%.
Before we trade we must decide our stop-loss, which we must absolutely respect.
Taking into account our stop loss and the proportion of capital we want to risk, we can calculate how many stocks we can buy.
We have decided beforehand the proportion of our capital we are prepared to allocate for each trade. This proportion should not be more than 20-25%. If we need more than this proportion to buy the security, we should limit the number of stocks, so that the amount of capital we invest is less than this proportion.
Finally, we calculate our trailing stop that will enable us to keep as much profit as possible.