There are two main parts to money management:
1) Risk control and
2) Position sizing.
Money management can involve other things as well, like your overall business or financial plan, but with trading it’s mainly about risk control and position sizing.
RISK AMOUNTS PER TRADE
"Before placing a trade you need to determine how much you are going to lose."
What? Did I really say that? Yes, I certainly did.
This lack of planning is the fundamental reason people trying to trade lose lots of money in the market. They don’t stop to think what they will do and how they will feel and react if the shares they buy goes against them and start to fall.
You need to determine from the very start what % of your trading capital you are prepared to lose if that happens. A common percentage is 2%, so lets use that as an example. Whatever risk percentage you choose, and whatever trade size you choose, they should be amounts you are comfortable with losing so that you can cope emotionally with the loss if it happens.
Risk control works like this… If you have a 50K trading account and you decide to buy a share and risk 2% of your trading capital that equates to a 1K risk because 2% of 50K is 1K. If you lose that 1k and your capital falls to 49K then for your next trade you calculate 2% of 49K which is $980 and that is the amount you risk on the next trade. The idea is that as your trading capital falls you risk less and less, keeping you in the game and decreasing your losses as you lose.
It works in reverse as well. If the first trade you do is a winner and your account goes to 52k, then in the next trade your risk will be 2% of 52k which is $1040, so you will be able to buy a few more shares than you could at the start of your portfolio when your initial risk was 1K. You are keeping your risk consistent with the rise and fall of your capital, maximizing profits by compounding when winning and minimizing losses by reducing your risk if you are having a bad run.
By keeping your risk small the chance of being totally wiped out is highly improbable, particularly because you are reducing risk as your capital falls. The chance of 50 losses in a row is 1 in 112,612,612,612,612.
You can also decide how much in total you wish to expose to the market. If you only want to expose 5K in total to the market you would only have 5 trades open at one time, so that if you were unlucky and they got sold out together your total loss is only 10% of your trading capital or 5K, leaving you with 45K to gather yourself, re-assess and keep trading.
"Position sizing answers the question “How many shares of each stock do I buy"
Once you have established your risk amount, and, if you remember, we have chosen 2% as an example, you need to determine how many shares of each stock you will buy. This is one of, if not the most important aspect of trading. If your position size suits the stock you are buying, it will make more difference to your end results than anything else, apart from obeying sell signals so you are not selling too early or too late.
A simple way of deciding your position size is to divide your capital evenly, like I did in the "I know what you want" section. The 25% stop loss trading system was discussed where the capital was divided evenly by 10, giving us 10 positions. So with our 50K portfolio we would 10 stocks and divide 5k by the share price and then buy that many shares. However, a problem with this method is that it does not take into account the individual risk of each share.
Some shares are more volatile than others and any system will work better if you allow for this factor when calculating position size, rather than using a simple percentage rule. The percentage rule works well but can be improved.
The best method to calculate position size is to determine how many cents per share you are prepared to have move against you before you sell. With slow stocks you may allow, say, 20 cents, where with volatile stocks you may allow 80 cents, to give them room to move up and down without you getting “whipped” in and out of the trade.
Calculating position size is quite easy once you decide on your exit strategy. You need to do this first so a position can be worked out.
So you need to know three things:
1) Your risk percent …in this case 2%
2) the dollar amount your risk is, in this case 1000
3) Your exit, and for this example we use a 7/12 EMA crossover.
If you are struggling to understand the very important strategies of risk control, exits, position sizing and money management, or some of the above terminology, I recommend you do some reading on it or seriously consider doing a course to improve your knowledge.