Published: November 18th, 2020 by Andrew
Money management is what allows you to protect your capital and optimize your online trading performance.
From this introductory session, you should keep in mind that if you do not apply rigorous management for your capital, you will never be able to “win” on the financial markets! But, what does it mean to manage your capital well?
Put simply, managing capital well means choosing the right size of each position, knowing how to place stop losses, taking into account the risk / return ratio and … much more. In summary, proper money management will allow you to operate without stress.
Starting from this assumption, it is not wrong to say that money management is what makes the difference between a winning trader and a losing trader. If, in particular, you recently arrived on the financial markets, your goal should not be to make money, but … not to lose it!
Now, before trying to understand what are the main money management activities that you can carry out, it is certainly useful to remember that, in order to practice Money Management well there is no better way to start than opening a demo account. Some high quality brokers like eToro (official site) will allow you to do it and, moreover, also to learn from the best … by copying them (we will talk about it soon)!
So, all you have to do is prepare for this new journey: we will share with you everything you need to know about money management!
Read also: Forex Demo to try Forex without deposit
Money Management in Trading
We define money management as risk management in trading.
Novice traders often do not pay particular attention to it, but they are wrong: it is, in fact, the key to success in the markets! Remember that you cannot “win” in the long run without following the rules of money management. Always keep in mind that your capital is your trading tool. So you will have to protect it every way, because without its conscious management, you will risk eroding your balance quickly.
Maybe it might be surprising for you, but it’s not a bad trading strategy that makes most traders lose, but bad risk management!
Money Management and Psychology of the trader
The psychological factor always plays a decisive role in trading and unfortunately those who want to learn how to invest underestimate this aspect: the psychology of trading can make the difference between making money or losing money.
In some ways (but be careful, only in this sense!) Trading could be compared to gambling for the emotions that “activates” in the trader, namely greed (the insatiable desire to make money), stress, euphoria, depression, fear of losing (which sometimes turns into Panic Selling), frustration and panic.
All these emotions allow traders (especially beginners) to make irrational decisions and endanger their work tool, that is their capital. And it is precisely here that money management comes into play: it allows you to protect yourself from emotions by following certain rules.
In trading, novice traders often only think about the gains they can make, but never about the losses!
Still, losses are part of trading and you can’t help but accept them. If you do not accept losses as an integral part of your growth path in the financial markets, you will probably never be able to achieve positive results. In other words, on the financial markets you cannot always be right: money management will be useful to manage the negative phases and will prevent you from burning too much money when things go wrong.
Read also: Best Forex Brokers, Safe Brokers List (2020)
Money Management and Leverage
Money management is also very useful when it comes to leverage-induced risk. But why?
Leverage, which heavily influences the risk of your strategy, is calculated as the ratio between the total amount of your positions and the account balance. In other words, the bigger your position, the higher your risk and … you don’t need a financial expert to understand it!
This does not mean that leverage should be avoided to comply with your money management rules, but simply that you must open positions commensurate with the size of your assets. And this, of course, applies to all types of markets, from Forex to stocks, from indexes to commodities.
We would like to remember that leverage builds up on all your positions. The more positions you open, the greater your risk. However, this risk can be mitigated by diversification into different markets / products, making sure that the trend of one market / product does not drag behind it that of another market / product in the same direction.
Unfortunately, achieving good diversification, in an increasingly connected world, is very difficult. However, it is also a fundamental step that traders should always try to deal with with the right awareness. Again, keep in mind that the leverage that can be used also depends on where you place your stop loss. The further away your stop loss is, the more important it is to reduce the size of your position.
Read also: Our guide to Trading Indicators
4 basic rules of Money Management
Now that and you know a little more about Money Management, we want to go a little further and identify with you some fundamental rules that you could apply immediately.
These are 4 practical tips that may be right for you, and which we invite you to test by opening a demo account with one of the best brokers in circulation, such as eToro (here is the official website). In this way you will be able to experiment all our indications without any risk, choosing calmly whether or not it is appropriate to apply them also to “real” trading.
Use a Stop Loss
A stop loss is a level of protection capable of representing the price at which the broker will automatically close the operation, because – evidently – you believe this price to be the maximum level of sustainable loss.
Remember that stop losses are mandatory in every position, and if you don’t always place (we repeat: always!) a stop loss, your emotions will end up taking control of you when there are unfavorable price movements. And this, of course, is the beginning of the end!
In fact, even a single operation could be enough to ruin you (even with a low lever). Therefore, do not think that the price will always return to the entering price. Some trends last for several days, weeks, months or even years. Also, a losing trade that permanently appears in your wallet will penalize your trader psyche.
We also remind you that a stop loss must NEVER be moved if the price moves in the wrong direction! The stop loss level must in fact be decided before opening a position (this is in fact the only time when you will be objective!). And only a favorable change in the price should eventually result in a stop loss moving to follow the move and protect your earnings.
Evaluate the risk / reward ratio
We advise you to fix the stop loss in a “less distant” way from your entry price, in terms of points, than your target price. All transactions with a risk / reward ratio below 1 should be avoided!
For example, you should not take a position on the EUR / USD when buying with a price target of 1.1550 and a stop at 1.14 while the pair is trading at 1.15. The risk / reward ratio on this trade is (1.1550-1.15) / (1.15-1.14) = 0.50 / 1 = 0.5.
In principle, a good risk / return ratio is around 2. That is, the expectation of gain is therefore double the risk. Between 1 and 2 it is a tolerable ratio, but is reserved especially for more experienced traders. The less experience you have, the more important it is to select trades with a ratio of at least 2. This will likely reduce your trading opportunities, but a beginner usually has a lower positive trading percentage than an experienced trader, and therefore you need to compensate with a good relationship!
Read also: How much a trader earns (real data)
Adjust the size of your positions
For each trade, the target price and the stop loss will be more or less distant in terms of points, depending on the characteristics of the trade and the product traded. For each trade, it is therefore important to calculate the size of the appropriate position so as not to risk more on one trade than on another.
It is important that the risk is constant. On average, make sure that this risk does not exceed 2% on a position, even if we advise you not to exceed more than 1% and, if you open many positions at the same time, reduce the risk to 0.5% for each operation.
Set a maximum loss threshold
Unfortunately, in your career as a trader, you will have many dark days, in which you will face serious losses. Well, you have to – unfortunately! – accept this truth. Luckily it won’t always happen, but every trader has passed through it several times in his career! The important thing is, in this case, to limit the losses during these days and be able to return to trading without taking further risks in the following days.
It is therefore important to establish a maximum loss threshold, as a daily percentage. Once you reach this threshold, simply stop trading on that day and return to the next day. To determine this percentage, you can calculate your average performance on a winning day. Multiply this number by 2 and you will get your maximum loss threshold.
Money Managements: the limits
We have repeatedly mentioned in the last few paragraphs that money management is the key to success in trading. Still, we are fully aware that it is sometimes difficult to apply every principle of proper money management literally.
Sometimes, however, the technical aspects of trading complicate the situation. On Forex, for example, some brokers impose a minimum contract size of 1,000 units, or 0.01 lots (micro lot). It follows that if your initial investment (deposit) is too low, you will be forced to leverage all your positions.
In this case, strict money management will force you not to open many positions at the same time, as this would result in too high a cumulative leverage (i.e. leverage on all your positions).
Worse, if your initial investment is very small, applying the money management rules will penalize your trading results. In fact, not being able to reduce the size of the position, you will have to bring your stop losses closer together so as not to risk too high an amount on one operation, and therefore you will have a greater number of operations at a loss.
Of course, there is a remedy for everything!
For example, if you want to understand how the most experienced traders in the world do Money Management, a good solution is to copy the most established investors on the eToro trading platform (here the official website).
The eToro copytrading will allow you to automatically follow and copy the trading activities of the best investors in your community.
You will therefore be able to understand what they are buying and what they are selling and, in this way, improve your investment skills. An unmissable opportunity for novice investors, but also a good way to diversify the capital for more experienced ones.
We remind you that eToro’s copytrading is FREE and that you can try it at any time by opening a trading account on the official website.
Learn to trade with Trade.com
Another way to improve your money management skills is certainly to follow the best courses you can find online.
Among the most valid, completely free, there is also that of Trade.com (official website), which can also be easily consulted via the app. It is a course that step by step will allow you to acquire more knowledge on the correct management of money, thus allowing you to trade more consciously!If you want, you can take a look of the course here.
In this article we have explained in detail how to do money management to obtain optimal results with online trading.
We reiterate that doing money management is fundamental, it is one of the bases of trading. Often beginners ignore this simple strategy and then pay the consequences (maybe they are also convinced that with online trading you don’t make money).
It might be a good idea to experiment with these ideas with an online trading demo mode to increase understanding and also to develop your discipline.
Because it helps limit trading risks and control emotions.
It is an indication of the trading platform that closes a position if the losses exceed a predetermined level.
It is the relationship between the potential profits of a position and the associated risks.