Money Management Trading Strategy: Important Rules to Manage Risks

Traders use several risk management rules known as “money management rules” to protect their capital. These rules are designed to reduce the risk of bankruptcy and maximize a trading account’s risk-reward ratio. Whether or not to adhere to these rules often differentiates a winning trader from a losing trader.

This guide contains the money management rules and principles most often followed by independent traders to protect their trading capital.

What is money management?

Money management refers to all the strategies and techniques traders use to reduce their risk of bankruptcy and maximize their risk-reward ratio.

“The golden rule of trading is to focus on risk management, not profit potential. If you pay attention to losses, the gains will come on their own.”

This quote from Van K. Thart, one of the leading experts in trading psychology, emphasizes the importance of risk management in any speculative strategy. If you hope to earn money in the markets, the first thing you must do is survive.

No trading strategy has a 100% success rate. Therefore, to succeed in the long term, independent traders must learn how to manage their losing trades properly. 

Gains and losses don’t always balance out in your trading account. If you lose 10%, then gain 10%, you won’t be even. You’ll still have a loss. And the greater the initial loss, the greater the gain required to return to your starting balance because that amount increases exponentially.

If your trading capital takes a loss of -50%, you’ll need a gain of +100% just to get back to your starting balance. So, it’s easy to understand that, as Paul Tudor Jones said, trading is a game of defense, not offense!

Having money management rules in place increases the odds that traders will be able to stay the course and avoid allowing their emotions to alter their trading approach.

The fundamental principles of money management

The science of money management uses mathematics and probabilities to optimize traders’ chances of performance and survival. However, risk management rules don’t have to be complicated to be effective.

How to properly manage the money in your trading account: 

• Establish simple risk management rules
  Rules that are easy to understand are more effective than overly sophisticated ones. When you’re in the heat of battle, you have little time and cannot equivocate. It’s better to have a simple rule that’s easy to understand and execute at a moment’s notice rather than a complicated, time-consuming one that seeks mathematical perfection.
  
• Always stick to your money management rules
  Rules are useless if not followed. It’s better to have a few golden rules you follow all the time rather than many that you follow sometimes. Breaking a rule even once can have dramatic consequences.
  
• Don’t change your rules without an excellent reason
  Consistency is one of the keys to trading performance. Once your risk management system is established, you really don’t need to change it during your trading journey. If you choose to change it, make sure it’s not a ruse for breaking the existing rules.

The golden rules of money management

1. Establish a trading budget

You can lose a significant amount of money trading. Therefore, before you begin trading for real, you need to know exactly how much money you’re willing to risk losing in the markets. That’s the maximum amount you should invest in your trading venture.

Don’t confuse speculative trading with long-term stock investment. So, take as much time as necessary to establish your trading budget accurately.

2. Set your maximum loss amount

Losing trades are inevitable, and they can sometimes come one right after the other. To prevent a string of bad luck from bankrupting your trading account, set maximum loss limits per trade, per day, per week, and so on.

When you reach these limits, step back and pause to break the vicious circle you’re in. This measure allows you to avoid uncontrolled risk-taking while you try to redeem yourself by “winning your money back” at any cost.

3. Take variable-size positions

Depending on the trader’s ability and the market scenario, traders may take large or small positions. They may also enter and exit positions gradually.

Conventional wisdom dictates that traders should quickly exit or reduce their losing positions, boost their winning positions, and let the latter run. However, this runs counter to our natural tendency to take profit quickly (to ensure we get the profit) and refrain from cutting our losses quickly (hoping the asset will rebound).

4. Always place a stop-loss order

Traders are never immune to a technical problem that could prevent them from managing their position(s), including but not limited to a power outage, battery failure, computer bug, or when the internet is down. And even when they are able to click their mouse to close a position, they may not: The risk of not being disciplined enough to take the loss is very real indeed.

To avoid this type of setback, independent traders place stop-loss orders simultaneously when they enter their position. Stop-loss orders are designed to automatically close the trader’s position at a predetermined price level and are triggered when the price trends in the opposite direction of the position. Their size is equal to the open position.

By placing stop-loss orders, traders can limit their maximum loss exposure in advance, which gives them a certain level of calmness. This proven technique informs you of your trade’s risk-reward ratio, which you can determine by comparing the distance of your stop-loss order to that of your take-profit order.

Example of money management rules

Please note that the above example is provided for information purposes only. Your money management rules will need to factor in your personal situation, financial ability, and trading strategy.

Additional safety rules before you start trading

If you are new to trading, your goal is to survive long enough to have time to learn and gain experience.

Here are some tips to extend the life expectancy of beginner traders:

• Do not skip the paper trading phase
  Practicing on a trading simulator with fake money lets you discover trading at your own pace. Furthermore, you commit your beginner mistakes innocently in a pain-free environment. Do not skip this step under any circumstances!
• Start with spot trading
  Spot trading limits your risk exposure to the money in your trading account. It does not involve investing using credit, such as leverage. You’ll have plenty of time later to gradually start using leverage as a multiplier once you achieve proficiency.
• Trade minimally
  Trading with micro-positions significantly reduces pressure. Furthermore, having a limited number of trades lets you focus on quality rather than quantity. Overtrading or compulsive trading is indeed one of the biggest dangers for beginner traders.

Follow your risk management rules!

It’s good to have solid risk management rules. It’s even better to follow them! We’re human beings who can sometimes become victims of our emotions and biases and be tempted to deviate from appropriate trading behavior. We’re not machines or algorithms, so we need to set up our own rules and follow them to avoid temptation. Because, unfortunately, when we breach the rules we’ve established, it can end up being very expensive.

Here are some ways to be more disciplined in your trading: 

• Formalize your trading rules
  Commit your risk management rules to writing! This eliminates ambiguity and ensures clarity. Ideally, your trading rules should be prominently displayed in your trading office. Frame them and hang them on the wall next to your computer!

• Be resolute
  Don’t throw a wrench in the gears. If you make an exception (even a minor one) to your trading rules, you risk entering a vicious circle. Draw clear boundaries and always adhere to them.
• Keep a trading journal
  If you fail to follow one of your rules one day, rather than being upset with yourself, try to figure out what caused the error and remedy it. Specifically, what can you do to prevent this from happening again?
• Adopt a trading routine
  Sometimes, willpower is not enough to ensure compliance with your trading rules. Fatigue might set in, something unexpected might happen, and boom, you might slip up! Consider creating a trading routine to limit temptations and turn rule-following into a habit. Repeat the same actions every day, before, during, and after your session.

Some quotes about money management

In conclusion, and to inspire you, here are some quotes from famous traders regarding the science of money management!

“Money management is what differentiates gambling from speculating. Without money management, you’re doomed to the loser role.” Alexander Elder

“The one and only thing I can say about trading is that there’s only one rule: Stay alive. If you have a losing trade, the most important thing is to be able to come back to trade the next day.” Jack Schwager 

“Don’t risk more than you can afford to lose, but risk enough for a winning trade to make sense.” Ed Seykota

Capital is the trader’s primary working tool. By adhering to solid money management rules and techniques, you will significantly increase your chances of long-term survival and the probability of one day becoming profitable. 

But that’s not all. To improve the quality of your trading, you should monitor performance indicators such as the maximum drawdown and the profit factor.