Table of contents:
Successful trading consists of four key factors. You need to relate money management and risk management to your trading setup and your personal account size. Here you can find out how it works.
The topic of money management and risk management is admittedly a bit dry. I try my best to present it as pleasant and understandable as possible.
Especially beginners prefer to deal with the setup and backtesting of a new trading strategy rather than with money management and risk management.
Because my trading strategy or the complete trading setup can be as mature as I like and present great risk/reward ratios on paper.
If money management and risk management are not precisely taken into account, then every trader will make losses in the long run and ultimately fail.
But first of all we will look at the characteristics of both terms.
Difference between money management and risk management
Both terms are often mixed up or confused, which leads to
you deal with one of them, but rarely with both components.
But if I want to trade successfully in the long term, I have to understand the difference professionally and take it into account in practice.
Money management refers to the targeted use of available capital.
You think about how much money you want to risk per trade.
Basically, the more money I risk in relation to my total capital, the greater my risk.
Mentally, traders should always focus on the risk and not the potential opportunity.
The goal of money management is to achieve a steady return with low risk, which automatically makes the trading account larger.
Risk management is more general. It refers to the awareness of risks that generally exist in the market or in connection with an investment/trade.
In addition, not only the aspects of capital input but also all other influencing factors such as broker, black swan, correlation, etc. are taken into account.
Interim conclusion: Risk management is the big picture of the risk-adjusted investment. Money management as a part of it provides for a controlled and optimized investment of money for a constant increase of the account.
Up to now we know that as a trader I have to be aware of all risks that arise with an investment and act accordingly (risk management) and with the help of money management I have to ensure a risk-adjusted optimization of the invested capital.
We would like to list some of the risk management issues that you as a trader have to be aware of:
- brokers: Is my broker reliable in executing orders? Is he ALWAYS available? What happens if not?
- Asset: Is the market liquid? Could there be illiquid phases? What does this mean for my position?
- How do certain market events change my account balance?
- Is my trading strategy duplicable?
- Do the underlyings in my portfolio correlate positively with each other? Double risk?
There are many more questions that can be listed here, but now you have a first impression and an input that you can develop further for yourself.
In the next step we will show you examples from money management. This is mainly about calculating the right position size and a positive risk/reward ratio (CRV).
Money management examples
We now look at two traders, Peter and Stefan. They both have 10.000 EUR trading capital at their disposal.
Peter would like to achieve a CRV of 1.5 in the long term. Using the example of a DAX trade, this could look like this: Chance of winning 150 points (take profit), chance of losing 100 points (stop loss).
Stefan reaches a CRV of 1.2. 120 points profit means 100 points potential loss.
So far so good. But what is the point of these assumptions? Can we say that Peter is a better trader? Does he achieve better results?
The answer is no!
Because the CRV alone does not tell us anything about trading success. In order to have a reliable statement or a reliable measuring instrument, we have to put the CRV in relation to the hit rate.
The hit rate tells us how often we are right or wrong. If we have a hit rate of 40%, then out of 10 trades made there are only 4 profit trades and 6 loss trades.
Back to the example:
Peter has his 1.5 CRV after 100 trades, but has a 40% hit rate. Is he successful?
No. He is exactly at 0% return, which is still better than a minus, but not a trader’s goal.
Stefan has a 1.2 CRV, but a 50% hit rate. If he maintains these odds over a longer period of time, he makes a sustainable profit in trading.
This could be his trade history:
Trade 1: 120 Profit
Trade 2: 100 Loss
Trade 3: 120 Profit
Trade 4: 100 Loss
You can see that with a hit rate of 50%, the positive CRV will result in total account growth.
Conversely, a balanced or positive hit rate is uninteresting if
you have an extremely negative CRV.
This could happen, for example, if you take profits too early and let losses run too long.
The own money management
With CRV and hit rate, we have learned about other key figures, but not yet a functioning money management system.
It is imperative that we consider that a trade history as described above is rather unlikely. Sometimes you have 3 winning trades in a row, followed by 7 losing trades and vice versa.
If I have executed the 7 loss trades with 20% of my available capital each, then I have a little more than 2,000 EUR left over from an initial 10,000 EUR.
So now it’s a matter of determining reasonable position sizes for each individual trade, adapted to your own account.
How do you go about this?
We follow the approach of many professional traders and use the 1% rule of thumb. This rule states that a maximum of 1% of the account balance is risked per trade.
If I have 10.000 EUR on my account, my next trade will risk a maximum of 1%, i.e. 100 EUR.
Now that we have determined a fixed euro amount, the next step is to determine the position size, i.e. the number of units of the derivative.
Unfortunately, there is no blanket statement about this, because the number of units depends on your own trading style.
If I am a swing trader, I usually have bigger stops in the market than a day trader and even more than a scalper.
Let’s stay with a daytrader and risk 1% in DAX trading. With a CFD contract that would be 100 points that the market is allowed to fall. This is acceptable depending on the setup.
The Scalper trades with a higher number of units, because it is only looking for a few points. He wants to risk 20 points. Based on the 1% rule he could afford 5 contracts.
I hope it has become clear that the position size depends on the account balance as well as your own trading style.
How do I proceed in practice?
You have learned about CRV and hit rate as well as how to determine the position size. The examples illustrate the necessity, but should not be copied 1:1.
For my personal trading, these ratios are important, but they should not be stubbornly and consistently adhered to.
This means that I naturally try to achieve a balanced to positive hit rate and CRV, but I deliberately allow for technical inaccuracies!
In my opinion, it is necessary to remain a little flexible and to end a trade prematurely if the sentiment on the markets has turned and/or high volume breaks the trend.
Also the risk can sometimes be around 2-3% per trade, because my market experience and my self-confidence in the individual trade occasionally allows more. However, everyone has to decide this for himself.
At least as much time and attention must be devoted to your own money management and risk management as to the creation and review of a trading strategy.
I would even say that anyone who wants to trade professionally must spend most of their time, apart from dealing with their own psyche, with the constant application and optimisation of money and risk management.
Unfortunately, too many private traders make the mistake of putting this time emphasis on the constant review of the trading setup, which is the factor in trading that requires the least attention after successful implementation.
Finally, the advice that one should not look forward to a monster trade with mega profits, but should try to survive in the market in the long term through constant and sustainable (small) profits.
This is the only, the true way of the trader!