Ask three different traders what's the most important thing in trading, and it's likely you'll get three different answers.
One will say, 'market timing'.
Another, 'nope it's trading psychology'.
The third, 'nah, money management. That's the key'
Actually, they're all wrong. Each is equally important.
Because, like any three-legged stool, take one leg away and it collapses, sometimes violently.
This article will introduce you to two of the core concepts of money management, and how trading psychology plays an active part.
Trading is a business
It's important to have realistic expectations when trading. One of those expectations is that sometimes you're going to lose money.
In fact, you're going to lose heaps of it during your trading career.
The best you can ever hope for is your winners are more profitable than your losers.
Which in essence is what money management is all about; managing your trading business the way you would a normal enterprise i.e. more profits than expenses.
Probability in theory
Money management is the boring side of the trading equation.
It's fun to talk about trading strategies. Sometimes, it's even fun to get all touchy-feely and discuss our emotions while trading.
But, it's rarely fun to discuss cold hard math (unless you're a complete math nerd).
Like it or not though we must always be acting as a disciplined accountant to our own trading capital as the risk of ruin is a very real one otherwise.
In finance, the risk of ruin is a complex topic with some equally complex financial modeling involved. Certainly to complex for the likes of me to discuss with real authority.
So I'll make this topic of money management real simple:
- you must always maintain enough capital to cover losses and still be able to trade
- it's preferable to have more winning trades than losing ones
- the average of winners in dollar terms should always exceed the average of losing trades in dollar terms
Cutting losses short
One of the most common mantras in trading is to cut your losses short, and it's common for one very important reason.
You must do it to be profitable in this business.
You can win seven times out of ten but if you let market losses get out of hand you're going to lose your capital in the end.
While this makes perfect logical sense, the fact is beginners find it hard to do. Maybe even the hardest thing of all in trading.
Any loss of money is a direct hit to the ego and even the most rational among us can go to great lengths to avoid even a small loss.
On top of the damage to the ego, a predominant belief concerning money is there is never enough.
This belief means traders often dig in deep with both feet, holding losers in the hope they turn around - which of course they never do.
Just ask Nick Leeson all about that.
Letting profits run
Cutting losses though is only one part of the money management equation.
Letting profits run is the other.
Technical analysis is based on the concept that prices move in trends.
This means prices keep moving up in an uptrend, or down in a downtrend
If you're snapping constantly at the tiniest of profits, and not taking advantage of price trends you're not going to be successful period.
Pro traders slice up their capital
If you're new to trading, you might even think it's strange we're even talking about emotions.
But financial markets are driven by emotions.
The whole art of technical analysis is a visual display of fear and greed of the crowd, which is why trading simple patterns can be profitable - human nature never changes.
Fear and greed are present in the hearts of every trader too.
No discussion of money management is ever complete without also discussing trading psychology.
The best traders have learned to divide up their total capital into small portions.
Such as 2% as an end of day trader, or 0.5% as a day trader.
By only using a tiny amount of capital on any one trade idea, in the event of a loss (of which there will be many) you're not going to be wiped out one fail swoop.
If you portion up your capital you will always live to fight another trading day, and with a positive expectancy system, will over time come out ahead in your trading profits.