A key part of becoming a successful trader is the knowledge of money management. Without a proper understanding of Money Management is and is not, you can have the best trading systems and still blow your account out of the water.

What is Money Management?

Money Management is a big area, and can be confusing if you’re just starting out in trading. Money Management is simply the practice of how you allocate your money to certain trades or trading systems. I find it easier to break down money management into 2 areas, each with its own principles and concepts.

Money Management can be simplified into 2 areas:
Trade Management and Position Sizing

The broad subject of money management is simply to cover 2 topics:

• 1. Trade Management
• 2. Position Sizing

The more commonly discussed money management topic is trade management, simply because it’s effect on your trading capital and results is more direct and immediate. However, both subjects are equally important to your overall trading health, and are inter-dependent on each other. And because both subjects are important to your health as a trader, it makes sense to understand these 2 topics and how they affect each other.

Trade Management

Trade management is a subject which deals with how a trader manages an individual trade position. It covers the area of using stop losses and profit targets to close out an existing open position. Every properly planned trade will have the stop losses and profit targets mapped out before the trade is even placed. This helps the trader to reduce the chances that he or she will make a decision based on emotions, and help the trader to execute the trading plan in the heat of the moment.

The idea of a stop loss is to exit your position when your market moves against you, and not before.

Trade management uses the existing tools of market and limit orders to close out your trade position for either a profit or a loss, depending on what the objective of each order is. The idea of a stop loss is to exit your position when your market moves against you, and not before. The idea of a profit target is to close out either your entire trade, or part of, when the market hits your pre-determined profit target.

The idea of a profit target is to close out either your entire trade, or part of, when the market hits your pre-determined profit target.

While I have simplified the concept of stop loss and profit target orders, stop loss and profit target orders can be used in various combinations to manage your trade for greater effect, either reducing your risk on the trade, or allowing your trade to continue running with little or no existing risk.

Position Sizing

On the other hand, position sizing is about how many contracts or shares you should place on any one trade. The risk on each individual trade that you take will also affect your position sizing parameters, and in turn affect the size of the drawdown on your portfolio.

Position sizing is about how many contracts or shares you should place on any one trade.

In simple terms, the larger the position size you trade, the higher the risk to your portfolio. The larger the position size you trade, the potential for higher returns increases as well.

For example, starting with a $10,000 trading portfolio:

Assuming if you were to trade 100 shares of company ABC, your risk on this trade would be $200 and your potential reward would be $600. What it means to your portfolio is that:

• If you were wrong, you would lose $200 (or 2%) of your portfolio.
• If you were right, you would make $600 (or 6%) on your portfolio.

Now if you were to increase your position size to 200 shares, what it would mean to your portfolio would now be:

• If you were wrong, you would lose $400 (or 4%) of your portfolio.
• If you were right, you would make $1,200 (or 12%) on your portfolio.

By changing the position size of your trades, the risk and return on your portfolio would either be increased or reduced. While it may seem obvious on the surface, the effect on your equity curve would be dramatically changed over a series of trades, especially if you hit a streak of either winning or losing trades in a row.

The effect of position sizing can dramatically affect your equity curve over a series of trades.

Summary

Each topic itself covers a variety of details and implementation, and it would be easier to digest each topic on its own before combining the two together. However, when you understand that money management has 2 basic components to it, it will help you in managing your portfolio and how to allocate your trading capital down the road to reduce risk.

Smart Traders realize the importance of money management, and how one or two decisions in the area of money management can impact their overall portfolio returns. While money management is not the most interesting and exciting of topics, it’s a basic foundation to becoming a Smart Trader making steady and consistent profits not only in the short run, but consistently over the long term as well.