Money Management and Trade Selection

I have lost track of the number of times I have suggested to students they take small positions when they start trading. We advise students not to risk more than 5% of their account on any one trade but there is nothing wrong with taking an even lower risk, say 1 - 2%. Too often students try to “make a million” or double their account on their first trade. Impressive profits will come with time and effort but early in your trading career you should take the time to prove that your trading plan is sound before you risk too much on any trade.

Your first trades are still part of your education. They may be profitable but you will improve on your trade selection and management with experience. For example:

Let’s assume an account of $10 000. If we risk 5% on every trade, that is $500 per trade. If we aim for profitable trades to return 2:1 reward to risk ratio or better, then a profitable trade will be expected to return at least $1,000. That means we can have two failing trades to every profitable trade and still be at break even.

However, we know that with careful trade selection we should have more profitable trades than failed trades, plus a few break-even trades as well. Even if we have four profitable, four not profitable and two break-even trades from every 10 we take, we will be ahead.

However, if we have several unprofitable trades in a row, our capital will be reduced and it will be more difficult to recover the losses. This is not an invitation to increase our risk, as another loss of a greater amount would impact the balance of our account even more dramatically:

From our original account of $10,000 and risks of $500, we have two losing trades. This means our account balance is now $9,000 and we should only risk $450 for the next trade. If we then have two profitable trades at 2:1, we earn $900, so it will take a third profitable trade to be back where we started.

This is the point where some students panic and try to make back all their losses on the next trade. Instead, they should rebuild their capital slowly and focus on improving their trade selection to achieve better returns such as 4:1, 5:1 and even 10:1 returns. These trades will more than make up for any losses. Now let’s look at the same example of two initial losses reducing our balance to $9,000. Just one profitable trade at a 3:1 reward to risk ratio adds 3 x $450 and our account is now up to $10,350.

Money management is all about staying in the market long enough to become a good trader. Stick to your rules regarding how much you risk, where you take your profits and focus on learning to select better trades to produce better returns.

It’s the Journey

Lauren Jones