An often overlooked but essential aspect of trading: Money management
Money management is all about capital preservation, so that one will be able to stay in the game for the long haul.
Preserving your capital is the key to even staying in the game
Many traders tend to focus on achieving a high win rate in their trades, but an often overlooked but essential aspect of the trading process is also about money management. Money management is all about capital preservation, so that one will be able to stay in the game for the long haul and not let an unexpected streak of losing trades wipe out the entire portfolio. A phrase basically summarises it: “Trading is a marathon and not a sprint”.
As an example, a trader may have a high winning rate of 80%, but if the losses from the 20% losing trades are large enough to wipe out all the profits from the winning trades, the trading account could still be unsustainable over the long run. A common trading statistics is that 90% of all traders fail and while there are many reasons to account for the high failure rate, poor money management may be one key reason as to why trading accounts are blown quickly.
Example: A trader with high 80% win rate but less ideal money management
With that, here are some concepts that may be useful for staying in the game:
1. Stagger your trade position into different entries to limit your risk
When a trader has established a view on the direction of a certain asset, he/she may have the tendency to go all-in on a single trade. While that is surely up to one’s risk appetite, the risks are relatively higher as compared to splitting up the entries into different tranches, especially if the asset price does not move as initially intended.
As an example, in January 2023, a trader may establish that a trend reversal could be in place for the Nasdaq 100 index after seeing an upward break of a key trendline resistance and its 200-day moving average (MA).
He may choose to go all-in with a long-positioning in the Nasdaq 100 index there and then, but he should be prepared to weather the losses if things do not go his way. On the other hand, he may prefer to put in one-third of his intended positioning, wait for subsequent confirmation of the upward trend potentially on a breakout to new higher high, before building up his positioning further. On the downside, he may use a trailing-stop loss to protect his profits because capital preservation will always be the key to staying in the game.
The example is as depicted below. Fair enough, some may argue that he will be much more profitable if he chose to put in all of his intended positioning at one shot back in January 2023, but he will also run the risk of experiencing hefty losses if the breakout turns out to be a false signal, which could end up wiping out a significant portion of his portfolio. Staggering out the entries may allow one to seek for more signs of trend confirmation. Furthermore, a trend tends to build over a period of time, which should provide one with ample opportunities to buy on retracements or to buy on breakouts.
2. Limiting the amount to risk on each trade
However convinced you are in a trade setup, there is always the chance that it could turn out wrong. With that, being overly exposed to a single asset in your trading account can end up increasing the likelihood of taking on significant losses, even if you have risk management measures in place.
Placing a limit on how much to risk on each trade may avoid having a series of bad trades draining out all the profits in your account. This may be done through limiting a certain percentage of your portfolio eg. 5% or 10%, or by an absolute amount.
For example, if you have a system to risk 2% of your $100,000 portfolio on each of your trades, a drastic scenario of having ten consecutive losing trades will leave you with $81,700 to still stay in the game. In the case of using an absolute amount, with a system to risk $2,000 on each of your trades, ten consecutive losing trades will leave you with $80,000. Having a system in place and the discipline to adhere to it will help you avoid overextending yourself to just a small handful of trades, which may be the ultimatum to wipe out your portfolio.
3. Build on your strength and limit areas of weakness
After trading for some time, you will be able to clock some statistics on your trading performance for a certain asset (or how badly). Otherwise, the IG platform has a trade analytics tool to track your trades and provide you with a breakdown of key metrics such as return rate, win rate and profit/loss ratio on your trading history.
Based on the information, you will be able to establish which are your areas of expertise and also if your average losses are consistently towering above your gains. Instilling a suitable risk-to-reward ratio for each trade may be an approach to ensure that losses are kept relatively small as compared to potential gains. The key here may also be to focus more on your strength and reduce your position sizing at areas of weakness until performance shows significant improvement.
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