Money Management is a set of rules and specific techniques used for minimizing the risks and maximizing profit.
The risk is a maximum amount of assets that will be lost until a decision about closing of an unprofitable position is made. Thus, the risk is a difference between the opening price of a position and a price of the stop-loss order, or a reversal of a position multiplied by the trade volume.
General principles of money management:
1. The total amount of the invested funds should not exceed 50% of the total capital. This principle prescribes a rule about calculation of margin for open positions: the reserve sum available for use in non-standard situations and used for continuation of normal work must at least half of the total capital.
50% is a value suggested by Murphy. However, a lot of analysts believe that the invested funds must be from 5% to 30%.
2. The total amount of assets invested in the single market can not be more than 10% - 15% of the total capital. In this case, a trader is secured against investing excessive funds in one trade which can lead to the downfall.
3. The risk rate for each market should not exceed 5% of the total capital invested by a trader. In such a way, if the deal turns out to be unprofitable, the trader is ready to lose no more than 5% of the total invested sum. 5% is a value suggested by Murphy. However, Elder gives a value of 1.5% - 2%.
4. The total sum of the guarantee fees deposited when opening a position in one group of markets should not exceed 20% - 25% of the total capital. The markets of the same group have more or less similar dynamics. When trading on Forex, investors determine four major markets where the movement of currency exchange rates is quite similar: the dollar area, the sterling area, the yen area, and the euro area.
5. Determining the degree of portfolio diversification.
Diversification is one of the ways to secure a capital. However, the diversity should also have its limits. There should be a sensible compromise between diversification and concentration. A more or less reliable distribution of funds can be achieved by opening positions at the same time in four to six markets of different groups. The larger is the negative correlation existing between the markets, the higher is the diversification of the invested assets.
6. Determining the stop loss levels.
The value of the stop loss, first of all, depends on how much a trader is ready to lose in one trade. Secondly, it depends on how a trader assesses the situation in the market. Suppose that a trader has a dollar deposit in the amount of S. When opening a position, a trader allows a loss of L% of the deposit amount.
Suppose the contract for 100,000 was opened for buying USD against the Swiss franc (CHF), with that the cost of the opening at p1. Buy $100,000; Sell CHF p1 x 100,000. At what p2 level should a trader place a sell order in order not to exceed the order of acceptable losses SхL?
If your order at the p2 level has been activated, then the loss on the position would be: Loss – CHF (p1 – p2) x 100,000. On the other hand, the loss should not exceed the USD SxL, or in the Swiss franc (CHF) SxLxp2. Consequently, we have: (p1-p2)x100,000 SxLxp2. So here is the formula for the order’s level: p2 p1-p1 xSxL (SxL+100,000).
When determining the stop loss order, a trader should act from a reasonable combination of technical factors reflected on the price chart and considerations of protecting their own funds. The more volatile the market is, the further should be the stop loss set from the current price level.
It is in the trader's best interest to place a stop loss. At the same time, the “tight” stop loss can lead to unwanted closing of the position in case of short-term price fluctuations (noise). The stop loss orders placed too far are not sensitive to the "noise", but can result in significant losses.
7. Determining the ratio between potential profit and losses.
For each potential deal, a rate of return is determined. This rate of return must be balanced against the potential loss in case the market moves in an undesirable direction. Usually, such a ratio is set at 3 to 1. Otherwise, you should not enter the market. For example, if a trader supposes that the margin will be $100, then the potential benefit should be $300.
Since a relatively small number of trades during the year can deliver significant profits, you should try to maximize these profits while maintaining profitable positions for as long as possible. On the other hand, it is necessary to minimize the losses from unsuccessful deals.
8. Trading several positions.
Trend positions are executed with rather wide stop loss orders, which allow traders to keep these positions open in case of consolidation and price correction. Actually, these positions allow the trader to make the biggest profit. The trading positions are meant for short-term trading and are limited by fairly tight stop loss orders. As a result, when the price reaches certain targets, the positions are closed. When the price resumes its trend, the positions are restored.
9. Conservative and aggressive approaches to trading.
Most analysts prefer the conservative approach. For example, Murphy holds the same view, "The trader is acting aggressively when he strives to gain quick profits. The profits can be really significant, but only at the time when the market is moving in the favorable direction. When the market situation changes, the aggressive strategy usually leads to a failure."
10. Rules for opening positions:
a) open a position only when there is one major and at least one additional signal;
b) when opening a position, determine and write down the opening price, the price at which you will close the profitable position, the price at which you will close the loss-making position, and the estimated time of the position closing.
11. Rules for maintaining positions and partial closing till the estimated time:
a) support the positions only in case the analysis confirms the conclusion made earlier;
b) partly close the positions when receiving losses that exceed the calculated ones; if the price has reached the estimated level for profit making;
c) wait when receiving losses below below the calculated ones; if the price is at the same level; if the price has not reached the calculated level of profit.
12. Rules for position closing:
You should close positions:
- upon the expiry of the estimated time;
- having received the supposed profit;
- having received the supposed losses;
- having achieved the maximum profit.