Experienced traders always tell people new to trading that one of the most important things in trading is money management. However new traders are often left with no other explanation besides this with absolutely no idea of what this concept exactly means, what it implies and what it does in order to contribute to the success of a certain trading strategy. Then you have to add all the confusion that is generated within forums and trading communities where everybody seems to have a different version of what money management is, what its objectives are and what its effect is on a given system. On today’s post I want to help new traders by giving a clear definition of the concept of money management and how it is one of the most important aspects of trading system development. I will talk about the problem around the oversimplification of this concept, how it is mostly overlooked by most traders developing strategies and how you need to look at it in order to build up a holistic approach that uses this concept as the main focus of your trading strategy.
When you start developing a trading system or method there are many different parameters that you need to define that will tell you how to behave within the market. You need to define how your system will enter the market, how it will exit the market and how much lots you will be putting into each trade. Most people who do not understand the concept of money management well will simply associate money management with the amount of lots bought per trade, however this is wrong since money management does not simply deal with the amount of lots you use but with how much money your strategy makes or loses as a function of time. Money management therefore does NOT deal solely with the lot size traded per trade but with everything that finally determines the amount of money made or lost in average per trade in the long term.
We can think of money management then as all the different parameters that determine the magnitude of the average profitable and losing trade in the long term. This involves the system’s lot size per trade as well as the way in which the market is exit since all these parameters determine the amount of money made per trade. If you see money management does not deal with the way in which the market is entered since no inherent profit or loss – besides trading costs – are made when a trade is opened. In reality a trading system fails or succeeds in virtue of how it closes positions and not by how they are opened. This is why I tend to say that entries determine a system’s potential – by the mathematical expectancy of entries – but that money management -which deals with how much lots are bought on each trade and how trades are exit- finally determines a system’s profitability.
So it becomes clear then that this concept is a far more complex idea than what most people have in mind. Having a strategy with an adequate money management approach is therefore not reduced to having a strategy that just risks X% per trade but having a strategy that has exit mechanisms which maximize the potential of the statistical edge given by the way in which the market is entered. It is not only about determining the fixed percentage of equity risked per trade but also about building the strategy’s risk to reward ratio and its long term profit and draw down expectancy. Money management encompasses everything from the decision of the risk per trade to the placing of stop loss and take profit values, their adaptability against market conditions, the use of trailing stops, the use of internal logic exits, etc.
The goal of a strategy’s money management is therefore to handle the money placed within the market – a.k.a manage the money – so that it can achieve its highest potential for profitability with the minimum possible exposure allowed by the entry logic. Designing a good management strategy requires the quick ending of losing trades and the maximization of the potential of profitable trade in a way that will increase long term profitability.
Lack of adequate money management is the chief reason why most people fail even if they are all given an entry logic with a positive statistical edge (this will be the subject of another article) since the amount of money put into the market and the way in which it is managed is not correct and it doesn’t allow the potential given by the entry logic to be translated into a profitable trading strategy. Therefore money management is not only an important but a VITAL aspect of system design since it finally determines if a strategy is or is not profitable when an entry with a positive long term statistical edge is used. If you do not have adequate money management you can have the best possible entries and yet you will lose all your account in the long term .
Long story short, when you design a trading system you should put a lot of focus in the long term analysis of your strategy and how the market is being entered. How much money is risked per trade ? How are the exits set up ? What internal exit mechanisms reduce loses ? How can the potential of profitable trades be maximized ? etc. Having answers to these questions and understanding that money management is the cornerstone of a long term profitable strategy will probably allow you to develop much more effective, simple and robust trading strategies.If you would like to learn more about the design of likely long term profitable systems and how you too can develop your own based on sound and adaptive money management techniques please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach automated trading in general . I hope you enjoyed this article ! :o)
