The Money Management – Basic Principles

What is money management?

Many traders believe that the most important thing in trading is the knowledge of everything related to the market analysis or having a trading system with high reliability. It is true that these aspects are part of the success of a trader, but are only one part. However, one of the most important aspects of trading refers to the risk control and money management, because if we enter the market without a contingency plan for the worst case scenario, we are betting, not trading. We can spend much effort improving our trading system and gain knowledge about the market, but unless we develop a money management strategy we will not survive long in an environment as unpredictable as the market.

Money Management or Operational Risk Management is defined as the process of analyzing the trades according to risk and potential profits, determining how much risk, if any, is acceptable, and managing each position to control risk and maximize profit according to the equity in the trading account. Following the principles of preservation of capital, money management may consist of anything from a few simple rules to complex portfolio management theories. However, for most traders and investors, a common sense approach is more than enough to start earning money.

In this section I hope, for a moment, we will divert your attention from the search for the perfect system, so you can discover that you can turn a loser  system into a winner just by changing the rules of money management.

The Drawdown

One of the essential statistical data when assessing a model or trading system are the series of losses. Known as the DrawDown, this term means the amount of lost capital, expressed as a percentage of the total account balance. The Maximum Draw Down is a vital statistic that indicates how much capital was lost to achieve a given return. Its calculation starts when there is a losing trade and continues as the account balance continues to record new lows.

The Maximum Draw Down is the maximum drop in the account balance between two peaks of earnings. Note that a maximum of 100% Draw Down means losing the entire capital of the account even if preceded by earnings of 200%, 300% or 400%. For example, if you started with one count of 10,000 and lost 2,000, the DD is 20%. If, in the 8,000 remaining you win 1,000, and then lost 2,000, the DD is now 30% (8000 + 1000 – 2000 = 7000, that is 10,000 – 30%). But if you earns 4,000 after the loss of 2,000, you increase the balance to 12,000, and then lost 3,000, the DD is 25% (12000-3000 = 9000, 25% less than the maximum recorded of 12000).

How to recover from the Drawdown?

The best illustration of the importance of money management is the percentage of revenue needed to recover from a Draw Down. Erroneously, we think that if we lose 10% of our capital, we have to do is 10% to recover that loss. Not even close. The recovery rate from losses increases exponentially compared to the percentage of losses. A loss of 50%, for example, needs a 100% of earnings just to return to the initial balance before the losses The major difficulty in a leveraged market such as Forex is the asymmetric process that generate losses against the account capital, that is, the progressive or reverse capacity of the capital that have suffered losses to recover, because when the capital is decreasing it will generate lower profits at the same leverage.

Experienced traders and professional money managers are well aware of how difficult it is to recover from a series of losses. Those who have had long-term success also have a profound respect for risk. There are traders who gets phenomenal results for a time at the cost of not limiting the risk, but sooner or later the risk completely destroy their trading account.

The table below shows how the percentage of loss recovery increases exponentially compared to the percentage of losses.

Application of Money Management

We started looking at how difficult it is to recover from a series of losses. In this way we hope that the trader really understands the importance of risk management in trading. We can deduce, then, that is easy to lose money in the market, and even more difficult to recover for the accumulated losses. Perhaps is easier to lose in the market because there are far more probabilities to do bad things than to do right things when we are trading. But is that the reason?

Thanks to the statistics collected by some brokers, it seems that there is great misunderstanding of the basic rules of money management. It is impossible to know at what time the rules were distorted, but what should be called “Limit Losses”, was changed for something like “Imitating the losses,” and hence that 90% of traders fail constantly. In fact, their attempts to imitate each other, has swept the planet, and it will not be easy to put a stop to this situation.

For this reason, there is a proliferation of advanced techniques and indicators to lose money, tools to “take advantage” of the market when the spreads are higher, and effective hypnosis techniques to ignore mental stop loss.

To combine properly in this difficult task that is trading, the tools provided by the main analysis approaches with a solid money management, we will try to provide a series of key recommendations to be profitable in the market at the long term by decreasing the risk to the extent possible.

Best advice in trading: Always limit your losses

If you have lost money in trading, you may think it was because you do not have a good system, but in fact this is the reason number one used by beginners to explain why they lost the equity in their Forex account. Usually they say something like “I lost because I don´t have a good trading system” . These traders rarely admit, or are aware of, that they lose because they trade too much or risk too much in their positions. While it is important to have a good system, what really prevent to lose all the capital is a plan to avoid it.

It is very important not to lose all our capital when we are just learning.

It is very common that the beginners think that the money management is something to add to our trading when we have found the perfect system and we are making money. That assumption is erroneous, since the majority of rules related with a profitable trading plan which works in the long term have more to do with common sense than with sophisticated formulas. Off course a good trading system is necessary but it is not all and we must always remember this.

In the following article we will discuss 5 principles to achieve an appropriate risk management:

• Forex money management guide
• Common money management techniques