Main money management principles and tasks
The money and risk management is a critical part of financial market trading. While the market analysis (technical or fundamental) serves to answer the question of when and in which direction a position should be opened, the money and risk management answers other questions:
And so on.
First of all, any trader should understand and accept the incontrovertible fact that losses are inevitable: they are an integral part of trading, as is profit. They go naturally together like, for instance, day and night or two sides of one coin. As simple as this truth is, not every beginner trader can accept it. In an effort to make only profitable positions (some sort of idealism, so to speak), beginner traders break the fundamental rules of the money management. Specifically, they do not close unprofitable transactions in the hope that sooner or later the market would reverse and these transactions would bring profit, while profitable transactions are closed as soon as the smallest floating profit has been made (refer to Section 5.2).
It is absolutely wrong to think that in the process of sharpening trading skills you should strive to always determine correctly the direction of the market and open transactions in the direction of future movement based on the results of your analysis. Achieving such goal is practically impossible. Anyway, for the time being science does not know, even hypothetically, how to achieve this goal.
What does this mean? It means that at any given time point, the existing position is risky, that is, there is a risk of no profit or of making less profit than expected; there is also a risk of loss and it can be even bigger than expected. Thus, objectives of the money and risk management are:
At this point, we should note that money and risk management is worth discussing if and only if a trader has a certain formalized strategy. Otherwise, (if a trader traded this morning because he/she was in a good mood and yesterday because he/she had a side ache) it is only possible to analyze a posteriori what produced certain trading results (using a statement available). Unfortunately, we know from the experience that if a beginner trader who lacks experience and skills realizes that he/she can “see the market” (i. e. has an intuitive sense of future market movements) he/she starts making random “chaotic” transactions quickly resulting in a complete loss of the deposit, statement analysis, in which case, being only аn attempt to identify the causes and understand the biggest mistakes.
A strategy may not become a mechanic trading system, but it should, at least, include a code of rules giving answers to the critical questions (refer to Section 6.3.).
The second note we should make is about a close relation between potential profitability of the strategy and risks associated with it. At first glance, such relation looks proportional though it is not linear. It means that a reduction in risk would generally result in lower profit, whereas an increase in profitability would result in a higher risk. However, there are cases where increased risk does not lead to a bigger profit and, vice versa, lower profit does not reduce risk. Ideally, the goal of money and risk management is to create opposite situations, that is, bigger profitability with no increase in risk and a low risk with no reduction in profitability. Such goal can be achieved.
Let us make an important point that, mathematically speaking, is undisputable: if a strategy has a positive expected value (no matter how small it is) methods of money management can help achieve exponential deposit growth. In other words, if there is a strategy that, when used for trading at constant volumes, helps you increase the deposit, regardless of how small the increase is, it is possible to select money management rules for this strategy such that deposit growth would be exponential rather than linear. Consequently, there is some optimal volume of transaction for any strategy (for self-study, those who are interested can refer to the literature about optimal “Phi” (letter of the Greek alphabet)). In our course, going into details or mathematical calculations is not possible. Below are the most general rules for the money management.Next Prev