Basics: Money management for traders

The amount that you lose as a percent of your trading account is called drawdown. The picture below shows a 10000$ account which suffers a series of losses. The difference between the equity high and loss is called drawdown. A trader must try to minimize drawdowns for the long term survival.


The table shows percent of drawdowns and percent of required to return to recover the drawdowns. As you can see exposing unmanaged risk to the market can ruin your account. Therefore money management is important for traders.

Money management is a part of the trader system. It answers the questions of "How many?" and "how much?".

1. How many units of your investment should you put on at a given time?
2. How much risk should you be willing to take?

money management techniques are


Risk 2% on every trade: Never risk more than 2% of your invested capital. If you invest 10000 €, do not lose more than 200€ of this investment in a single trade. For example if you identified your entry point as 40€ and exit point at 38€, you would risk 2 € per stock. If you can risk 200€ in total and 2€ per share, you can find the number of share that you can invest in by dividing the 200€/2€=100 shares. You can buy 100 shares. That means you can invest 100*40€=400 euro in total for this trade.[2]

This basic method or other money management methods can determine whether your are allowed to enter the trade or not. For example if your expected loss is grater than your allowed risk exposure, you are not allowed to enter a trade.[3] You can use the same method to find out the total capital that you need have.

If a trader is exposing his total capital to more risk than allowed, this is overtrading. Traders should avoid to overtrade[1].

Cost averaging and pyramiding are not money management techniques. Cost averaging suggests that a trader should add more contracts to a losing position to decrease the average cost of the total contracts. Pyramiding is opposite of the cost averaging. It suggests that a trader should add more contracts to his wining positions[1].

Resources:
[1] The trading game, ryan jones
[2] Money Management Strategies for Futures Traders, Nauzer J. Balsara
[3] Special report on money management, Dr. Tharp, www.forexfactory.com/attachment.php?attachmentid=2488&d=1133658244
[4] Money Management (Pt. I):Controlling Risk and Capturing Profits By Dave Landry