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Money Management: Basic Pillar of Trading

23 Feb 2018,

This article isprobably the most important article from our trading series for beginners. Understanding the principles of money management is so important that it forms the basic pillar of successful trading.

Trading on the stock market is about risk management. We enter to a trade according to our analysis or based on programmed algorithmic strategies we use but always we have only a certain probability that our trade will be profitable. Every time we enter the trade, we also risk a loss, and we never know how the trade will end up.

For a better understanding of money management importance, let´s use a toss of coin example. If you toss and it is an eagle, you get $ 200, if it is a head, you lose $ 100.

100x toss of coinProfit/LossBilanceTotally
60 tossesLoss= 60 x -100– 6000
40 tossesProfit= 40 x 200+ 8000

Finally, your profit is 2000 USD, although you had more losses than wins. Because you earn $ 200 when you win, that’s twice as much compared to your loss, and you’re still profitable.

This whole example is only to demonstrate the idea and importance of the money management. It is not so important what is your percentage of profitable trades if you are working with the right money management. You risk $ 100 to earn $ 200, but you only have 40% profitability? Then you can be profitable.

Every trader has different money management

This example cannot be suited for everyone, because everyone works with money management differently. Depending on the type of the trader and his strategy, the profit of 100 USD and the risk of losing 200 USD may be sufficient, just because the percentage of profitable trades is 80%. In that case, trader can afford it.

But our trader from the first example, who has only 40% success rate cannot afford to have a $ 100 profit with a risk of losing $ 200.

Therefore, we need to test our strategy on historical data to gain understanding how it can be profitable, to see what the average profits and average losses are. If the strategy offers too low profitability and losses are not balanced by a big profit from successful trades, there is no point in trading that strategy.

 

Tip: For example, Zdeněk uses the StrategyQuant software, which creates thousands of strategies based on desired parameters and backtests them on historical market data (eg EURUSD).

Money management in practice

I am attaching the table below to help you to understand the importance of money management in real trading. To understand its full meaning, you need to know the RRR, or so-called risk reward ratio – potential profit from the trade.

What does RRR define?

It defines our stop loss. Simply said, if we enter on the value 1000, we place stop loss at the value 900 and our profit target is 1200, our RRR equals 2: 1 (= We risk 100 to get 200). If we risk 100 USD to get 50 USD, the RRR will be 0.5. Please see the table below.

RRRWin ratioProfit for 100 USD
0,566,67 %50 USD
150 %100 USD
1,540 %150 USD
233,33 %200 USD
2,528 %250 USD
325 %300 USD
3,522,22 %350 USD
420 %400 USD
4,518,18 %450 USD
516,67 %500 USD
5,515,38 %550 USD
614,29 %600 USD

To make it clear, “Profit on investment 100 USD” is calculated in the way that you will end up with your trading on zero. There is no slippage or commission to the broker. It should serve as an approximation of the idea that although our strategy can generate a lower percentage profitability, it may still be profitable. Your real-life strategy must have even better values ​​than the one in the table above. But if you reach the values similar to those in the table, you can push fortune and profitability to your side with small strategy changes.

Everyone would like to get at least 2 USD back or much more from each invested dollar, but here we are limited by the maximum values ​​of our strategy. In real trading, this means that if we want a higher return, the market has to make a much bigger movement in our direction. Imagine a chart, if we want to get back 5 USD from each dollar invested, we have to manage 5x longer distance than the distance from our stop loss to our entry, and this is very rare even with volatile markets.

Imagine it practically. We would have to get into a trend that will continue in the long run. For example, the end of the Czech National Bank intervention more or less offered such an opportunity. In less than a year, the dollar’s price has fallen from CZK 25.76 to today’s CZK 20.6.

So, do not try to get a higher profit than a loss at any cost, it’s not important. Focus on long-term money management and protect your account from large losses so you do not unnecessarily erase your account.

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