The science of risk management, money management allows the trader to control the risk exposure of their trading account and to optimize its return. In a field like trading, where psychology plays a central role, good money management rules will often make the difference between winners and losers (provided they are applied with rigor and consistency!).
It is not uncommon to see good trading strategies fail for lack of proper money management. By developing a set of consistent risk management rules, the trader can, instead, anticipate with greater precision the risks to which money will be exposed, and he can therefore work more calmly to build his performance.
If you want to make money in the financial markets, you need to understand the fundamentals of money management and develop your own rules. Here is our summary of the information to understand how to control your risk level and optimize your performance.
Why adopt a Money Management system?
Trading is essentially about taking calculated risks. To be successful in the long term, the trader must take care to control his risk exposure so that it is high enough to allow an attractive return on investment without endangering it. This is where money management comes in, to manage the risk of trading, maximize earnings, and minimize losses. In short, it optimizes the risk / return ratio of a trading account while taking into account the trader's investor profile.
Although virtually all traders are aware of the benefits of good risk management rules, not all of them follow them to the letter. And for good reason, it is not always easy to take the time to define these rules, to apply them to each operation, and to be sufficiently disciplined to follow them in all circumstances (even and especially in the case of a loser position).
As shown in the table below, the damage caused by controlled trading losses can be very difficult to overcome…
|Percentage of lost capital||Performance required to recover lost capital|
The higher the initial loss, the more difficult it will be for the trader to recover. A loss of -50% will require a performance twice as high, +100%, if only to return to the initial balance! You will understand, prevention is better than curing, because whatever your level of trading, to raise these kinds of losses is not easy.
With the democratization of leverage (a credit investment capacity offered by most online brokers), with the slightest increase in volatility, losses can widen very quickly. The need to adopt a comprehensive risk management system is therefore more relevant than ever.
But it's also important to remember that in some situations even the best risk management system in the world may be ineffective, especially when the trader remains in a position when the market closes. The trader is exposed to the risk of “Gap”, that is to say the risk of seeing the market “shift” suddenly when reopened. To avoid this type of disappointment, it is better to limit its use of leverage, but also especially avoid staying in position when the market closes. An approach like day trading allows you to to simplify risk management here.
4 tools to properly manage your risk exposure
One of the first (and most important) decisions a trader must make is to define the level of risk he is willing to tolerate. To do this, several tools can help him.
The Stop Loss
The stop loss order allows, as its name indicates, to cut the losses of a trade. Thanks to the positioning of a stop loss order as soon as it enters the position, the trader can indeed control the maximum loss to which he wishes to expose himself (either by adjusting the stop loss level or by playing on the size of his position). All things being equal, the closer the stop loss level is to its point of entry, the lower the risk, and vice versa. When the market moves in the direction favorable to the trader, it is possible to opt for a trailing stop loss (Trailing stop) able to accompany the evolution of the market and to protect the gains of the trader as and when they occur.
It is also possible for the trader to set loss limits (daily, weekly or monthly) that will work similarly to a stop loss. Rather than being expressed in monetary terms, these rules can also be expressed as the number of losing trades (consecutive or not). To know where to place their stop loss orders, traders generally use technical analysis.
The mathematical expectation
The mathematical expectation is a probabilistic concept. It represents the average expected result for a trade, and is the sum of the expected average gain multiplied by the probability of gain and the expected average loss multiplied by the probability of loss. The important thing for the trader here is to have a positive mathematical expectation.
Even a 99% success rate strategy won’t be interesting if its mathematical expectation is negative, since it could mean that the 1% of remaining trades are likely to cause very heavy losses.
Value at Risk (VaR)
Value at Risk (also called VaR) estimates the maximum loss to which an investor is exposed. It is based on three factors: the level of confidence, the time horizon, and the distribution of returns (assumed to follow the normal distribution). The trader can thus determine (with a confidence level of 99.99% for example) the maximum loss that he could record during a given period of time (over a month for example).
The maximum drawdown is the maximum decline in asset, portfolio or strategy from its previous highest point. This historical data estimates what could be the maximum magnitude of the next declines.
2 indicators to optimize your risk / return ratio
In order to evaluate the quality of your money management, it is not enough to focus on the control of losses, but the performance obtained must be attractive in view of the risk taken.
The Sharpe Ratio
The Sharpe ratio is the net return obtained per unit of risk. It is calculated as the difference between the return and the risk-free rate and then dividing this net return by the number of risk units (expressed in standard deviations). By comparing the Sharpe ratios of two strategies with different risk levels, it is thus possible to select the best performer (the one with the highest Sharpe Ratio, the one with the highest net return per unit of risk).
The Profit Factor
The profit factor is obtained by dividing the sum of the gains by the sum of the losses. Thus, the more lucrative the strategy, the higher the Profit factor. This indicator measures the quality of your performance.
Thus, it will not necessarily be the strategy with the highest performance that will be judged to be of better quality, but indeed the strategy succeeds in generating gains while controlling the level of losses.
Automating Money Management
Thanks to automatic trading, it is now very easy to define the stop loss levels. Risk and performance indicators are also easy to calculate and can be provided by most trading platforms. However, all of this information is useless if the trader does not take action to follow, in every circumstance, the risk management rules he has defined.
In the face of the turmoil of the financial markets, the human mind has great difficulty in resisting emotions and remaining impartial every situation. The more hours and sessions that pass, the more difficult it is to stay disciplined. Sooner or later, many independent traders end up making a discrepancy, and the financial penalty can then be irreversible.
To avoid the pitfalls of human nature and work the free spirit, most traders today choose to delegate the application of these rules of money management to an impartial entity: the machine!
Whatever the time of day, regardless of market conditions, and regardless of the trader's emotional state, trading algorithms always stick to the original plan and the risk remains under control. Learn how to automate your money management tasks in our latest Masterclass.