Home Guides Trading for Dummies Risk Management-I – Novice Guide To Effectively Manage Your Capital!

Risk Management-I – Novice Guide To Effectively Manage Your Capital!

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Money Management is the second most crucial part of trading right after trading psychology. But generally, novice traders neglect this as their only focus will be on gains and technical analysis.

What is Money Management? 

Money Management AKA. Portfolio Management can be defined as a process in which investors save and budget the usage of their capital. It is a guarding concept of keeping your funds secure before you take any trade. In the world of financial trading, after all, it is essential to know how to manage your capital, especially while trading the most volatile financial markets like Forex and Cryptos.

Why is Money Management important?

Many aspiring traders put their focus into their trading education. They learn trading strategies and candlestick patterns to trade the markets better. This is obviously important, but these traders ignore that they need to focus on money management skills as well if they want to be successful in the world of trading. When you pursue trading as your profession, the last thing you would want to happen is blowing up your account and get taken out of the game. So your entire focus should be on preserving and protecting your capital.

Not just novice traders, but also many of the successful traders suffer when they do not adequately do their money management. So it is vital to spend some time to understand the techniques of money management along with the Technical Analysis.  Solid money management can eliminate losses and reap you a lot of profits if used in a strategic manner. Hence, Money Management is vital for every individual who aspires to become a professional trader.

Steps in Money Management Process

Most importantly, the trader should decide whether if he/she wants to proceed with the signal they choose. This, in particular, is a severe problem when more than two securities are competing for limited capital in the account. Then for every signal accepted, the trader should decide on the percentage of the trading capital they are willing to risk. The goal is basically to maximise the profits while protecting the fund against any loss that could incur. This is very important because only if the capital is protected, a trader can participate in the trades further.

The best way to protect the capital from getting liquidated is by fixing a particular dollar amount for every single trade and not crossing that number what so ever. For each signal chosen, the trader should decide the price, which confirms that the trade is not measuring up to expectations. This price is also known as the stop-loss price or the stop price. The difference between the entry price and the stop-loss price defines the maximum permissible risk per trade. The risk capital allocated to the trade divided by the maximum permissible risk gives us the number of contracts to be traded.

Money management fundamentally comprises the following steps.

  • Ranking the best possible trades
  • Deciding on the part of the capital that you are willing to trade
  • Distributing the willing-to-risk capital across the trades
  • Assessing the level of loss for each opportunity that you can afford to lose
  • Deciding on the number of contracts of a security to be traded

Ranking the best possible trades

Start by ranking all the available opportunities to trade. The desirability of a trade is measured in terms of its expected profits, the risk associated with it and the investments required to initiate the trade. If the profit is higher  than the risk taken, that would obviously is the best scenario for any given trade. Similarly, if the investment required to initiate the trade is less, the trade is more desirable.

Deciding on the part of the capital at risk

Second, by controlling the overall exposure, a trader can maximise the profits and mitigate the risk. This means, if you allocate 100% of the capital across your top chosen trades, there is a risk of losing your entire portfolio if you lose all the trades you placed. At the same time, if you risk very minute percentage of your capital for the trades you chose, you might mitigate the risk of losing your capital, but you hardly see any profits. So there should be a right balance between these two in order to maximise your profits.

Distributing the capital at risk among all trades

So once you decide the total amount of capital to be risked for the trades you chose, allocate that capital across competing trades. The best way to do this is to allocate the fixed amount of capital for all the trades you chose when you are not sure about the risk to reward ratio. But once you know the potential of the trade, you can then increase or decrease the amount of capital on one particular trade in order to maximise the profits and mitigate the loss. Once you are done allocating the risk capital, the next step is to assess the maximum loss that you could afford to lose on a trade.

Assessing the level of loss for each opportunity

This step separates winner from losers. Accurately forecasting the loss in unpredictable financial markets like Forex and Cryptos is where the secret sauce of trading lies.  It is tempting to ignore the risk by concentrating only on the reward, but a professional trader should not fall for this temptation. There is no guarantee in trading what so ever, and a trading strategy which is based on hope than realism would rather fail than win in most of the scenarios. Following these principles, traders can mitigate most of the risk and can protect their capital in the highly volatile Forex and Crypto markets.

Stop-loss and Trailing stop-loss  

Stop-loss

Stop-loss, by definition, is an order placed to buy or sell once the security reaches a specific price. A stop-loss is designed in such a way that it limits an investor’s loss on a security position. Setting a stop-loss order 5% below the price at which you bought the security will limit your loss to 5%. For instance, let’s say you just entered a buy trade on USD/CAD forex pair at 1.3100 and placed your stop-loss at 1.3080. This limits your loss to 20 pips on the trade in the worst-case scenario.

Trailing stop-loss

Stop-loss can only prevent your losses, but ‘trailing stop-loss’ can lock-in your profits as well. It is a type of stop-loss order which combines both risk management and trade management. They are also known as profit protecting stops as they help traders to lock in their profits achieved on a trade. You can set up trailing stop-loss on to your trades with a single click of a button in most of the trading platforms.

How does a Trailing Stop Work

A trailing stop-loss is initially placed in the same way as a regular stop-loss order. For a long trade, a trailing stop should be placed at a price that is below the trade entry. The fundamental difference between a conventional stop-loss and a trailing stop-loss is that the trailing stop-loss is dynamic. That means it can move as the price moves. For every pip the price moves, the trailing stop would also move a pip. Trailing stops move in the direction of the trade only. So if you are long and the price moves up by 15 cents, the stop-loss will also move up by 15 cents.

But the beauty of the trailing stop-loss is that, if the price starts to fall, it doesn’t move. Let’s take an example. If a long trade is entered at $50, a ten-cent trailing stop would be placed at $49.90. If the price moves up to $50.10, the trailing stop would move to $50. If the price continued up to $50.20, the trailing stop would move to $50.10. But if the price moves back down to $50.15, the trailing stop would stay at $50.10. If the price goes down and reaches $50.10, the trailing stop would exit the trade at $50.10, protecting your profit of ten cents.

Trailing stop-loss works the same way for a short trade. The only difference is that when we short, we are expecting the price to drop. Hence, a trailing stop loss is initially placed above the entry price. If a short trade is entered at $30 with a 10 cent trailing stop-loss and if the price moves to up $30.10, we are stopped out with a 10 cent loss. If the price drops to $29.80, our stop loss will drop to $29.90. If the price rises to $29.85, our stop loss stays where it is. If the price falls to $29.70, our stop loss falls to $29.80. If the price rises to $29.80 or higher, we will be stopped out of the trade with a 20 cent profit.

Some traders use trailing stops with every trade they take, and some traders never use them. We strongly recommend you to use them as it is one of the potential money management tools. You can set a stop-loss to move automatically, or you can also manually adjust the stop-loss according to your preference. Remember not to set a trailing stop-loss too close to the entry as that may result in a premature exit. Understand that the fundamental purpose of the trailing stop-loss is to lock in profits as the price moves in favour of your direction and to get you out if the price is potentially reversing.

Finally, we can conclude by saying Stop-loss is a type of insurance policy. You hope you should never use it, but if at all the odds are against you, it will help you in protecting from incurring significant losses.

Position Size Calculator   

Position Size basically means the number of contracts or units of security you are willing to buy or sell. We see a lot of traders struggling to understand how to calculate the position size. It might sound confusing in the beginning, but with practice and experience, you can master the art of calculating perfect position size, which will make you a better trader. We will try to keep this concept of calculating Position Size as simple as possible. Few things you should know before trying to calculate the position sizes are as follows.

Entry is the price at which your order to buy or sell is executed.

Capital is your account balance and stop-loss is your order to close a losing position to prevent further loss.

Risk Amount is the capital you lose on the trade if your stop-loss gets triggered.

Liquidation is the forcible closure of your position.

One important thing to remember is that the Position Size and Risk Amount are not the same. This might sound obvious, but many traders out there believe that these both are similar terms.

To calculate your position size, you must know the amount you are willing to risk, your entry point and your stop-loss. The simple formula to calculate position size is to divide the Risk amount with the pip distance to your Stop Loss. There are a lot of tools online that provides price action, like tradingview.com, to help you in calculating the distance to your stop-loss.

Position Size = Total Risk Amount/Pip_distance to stop-loss

The pip is the fourth decimal place of the quoted price in all pairs or crosses except those related to the Yen, in which case is the second decimal place. Therefore, to compute the pip distance to stop-loss is rather easy:

Pip_distance to Stop-Loss = Absolute value (Entry_price – stop_Price) * 10,000 (or 100 in the case of the Yen-related-pairs)

Example of Position Size Calculation

Let’s say I want to trade EUR/USD on FXCM, and I want to calculate my Position Size. I’m shorting, my capital is $2000, and the Risk Amount is 3% of my capital, which is $60. I enter the trade at 1.13644, and I want to place my Stop Loss at 1.13998. I use a tool in tradingview.com to calculate the pip distance from the entry to stop-loss, which is 0.32% or 35.6 Pips.

Chart Credits – tradingview.com

As per our formula, Position Size equals to Risk amount divided by the distance to your Stop Loss. When we substitute these values, Position Size = ($60/35.6) which is 190184 Units or 1.902 Standard Lots.

This is one of the most accurate ways to calculate the appropriate position size. The expression of having a ‘tight stop’ should now make more sense. The closer your stop-loss to your entry, the larger Position Size you can trade while keeping the risk amount the same.

Let’s say we have two traders, Shyam and Shiva, trading EUR/USD on FXCM. The Capital, Risk Amount, and Entry positions for both of these traders are the same, but the only difference is their stop-loss placement.

Shyam – Tight stop-loss

Chart Credits – tradingview.com

Capital – $10,000

Risk Amount – 3% of $10,000 = $300

Entry – 1.13643

Stop Loss – 1.13851

Distance to Stop Loss – 0.18% or 20.6 pips

Position Size = Risk Amount/Distance to Stop Loss

Shyam’s Position Size = 300/20.6 = 14.56 Standard Lots

Shiva – Wide stop-loss

Chart Credits – tradingview.com

Capital – $10,000

Risk Amount – 3% of $10,000 = $300

Entry – 1.13643

Stop Loss – 1.14001

Distance to Stop Loss – 0.31% or 35.6 pips

Position Size = Risk Amount/Distance to Stop Loss

Shiva’s Position Size = 300/35.6 = 8.43 Standard Lots 

Therefore, it is a balancing act. A tighter stop-loss might give you bigger Position Size, but you will have less breathing room. Contrarily, a wider stop-loss gives you smaller Position Size, but with more breathing room. The bottom line is to understand that stop-loss placement should be given the utmost importance and its placement will depend on the type of trader you are, but it should never be arbitrary.

These are some of the fundamentals of Money Management and of course, there is more to it. In our upcoming article, we’ll discuss more complex Money Management concepts like ‘The Risk to Reward Ratio’, ‘Assessing the Magnitude of Loss’ etc.

 

2 COMMENTS

  1. You mention the importance of calculating the position size based on stop-loss, but unfortunately, the formula will only work if your account is in USD and the profit currency of the currency pair (or CFD) is also in USD. Otherwise, you need to use adjustment calculation. This can be done easily with Position Size Calculator in MT4/MT5: https://www.earnforex.com/metatrader-indicators/Position-Size-Calculator/
    The indicator is free and can be used to calculate position size based on various risk tolerance settings. Regrettably, it doesn’t work with TradingView.

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