Why is money management important?
On the face of it, money management seems like a pretty straightforward task. You just have to be smart while investing it right? Well, there’s a lot more to it than that. Effective money management is all about making informed and smart decisions when it comes to investing, spending, budgeting and saving.
Be it a business, your personal finances, or investment management in trading, everyone needs money management. If you want to become a successful trader, proper financial knowledge and direction is essential.
A lack of experience, skills and emotional control are some of the main reasons why traders lose money. This is where money management is important- to keep risks and losses at bay. Financial trading markets can be volatile and are prone to risk, and money management is an effective way to mitigate the effects of that risk.
For all kinds of traders- day, swing or scalpers- money management needs to be applied to every trade you place- it is a crucial skill if you want to extract rewards and minimise risk. Here are some simple but essential tips that you can use to maximise your profit while trading.
Tips to manage your money while trading
Don’t invest when you don’t have enough
The first rule in trading is: do not put money in your account that you don’t have. If you can’t afford to bear the losses on your invested capital then you should not use that money. Trading requires having proper knowledge and the ability to make informed decisions.
Use Stop Loss and Take Profit
One of the most basic practices followed by traders is how to set a proper risk reward ratio. This can be done by finding out in which direction your trade is going and how far the market will favor you. Keeping this calculation in mind helps you in establishing your Stop Loss (S/L) and Take Profit (T/P) orders.
For a beginner, the traditionally used ratio for currency trading is 3:1. Using a lesser ratio is bound to become too risky. If a trader is experienced, this ratio can be extended to 4:1 and should not go more than 5:1 ideally.
How to set up a Stop Loss and Take Profit:
- Note down what the target profit is in pips. This can be set by analysing predicted price levels and the current price in the market.
- When this number is established, divide it by the advised risk-reward ratio and calculate the maximum permitted negative price movement.
- You can now set your S/L and T/P by using the numbers of your target profile and a tolerable risk value and evaluating in pips the distance from the current market price for both the risk and the reward amount. From these values, you set your S/L and T/P levels.
You should always keep a stop loss for every trade you place, to save you from suffering losses and heavy price movements. Trading should be strategic and not based on luck or superstitions, so it is necessary to take stop losses seriously. When you reach your target profit, close the trade and enjoy the rewards from your trading.
Set up a spreadsheet
It’s very easy to let emotions and energy get the better of you when you trade. It’s not unusual for traders to eventually get sloppy and lose track of trades. This is why you should maintain a spreadsheet to track your trades. Set up categories, columns and rows for assets purchased, quantity purchased, the commission for the trade and even the time of the trade. Set up similar categories if you close the position.
You should also evaluate your performance based on the change in the security’s price and the percentage you got on your trade.
Maintaining records in a spreadsheet can help you to analyse how much you stick to your strategy, but can also help you come up with ways to improve it. It can be used as a yardstick to measure the success of your trades, and can be useful when you have to pay your taxes.
Make a Profit and loss statement
This is an extension of the spreadsheet practise. At the bottom of your trade tracking spreadsheet, you should set up a summarisation of the day trade’s performance, including trading profits (after deduction of commissions), the percentage of the trading capital’s profit, the ratio of wins and losses etc. These final figures should be put in another spreadsheet, the Profit and Loss statement, so that you can have a bird’s eye view of your performance and success/failures.
Maintain a trading diary
It is essential to systematically evaluate and assess your trading, and a trading diary helps you to do just that. In your diary, you should write in detail your rationales behind indulging in a particular trade at the very moment, to help you keep track of your thought processes. It can be a signal, a hunch or some other market information, but these thoughts are important to document as soon as you have them.
Some people make diaries in different ways- for example, some traders use a form that they can easily fill during the day. At the end of the day, they compile all the filled information in a folder/binder and use it at later stages to look back at their performance and strategies.
Traders who are super busy can also use shorthand or similar strategies to write down their ideas and keep a tally of their trades. Find whatever method works best for you, and use your diary to keep track of your trading impulses.
Benefits of Money Management
- Through the use of money management tips, you can formulate defensive strategies to preserve your capital and maintain profits.
- It saves you from draining your account when you experience a series of losing trades.
- It prevents you from overextending yourself and overestimating your profits when you are doing well. This helps you to avoid a shocking loss that might drain out all the profits earned over a period of time.
- Money management can keep a trader profitable even if they have less than 50% winning percentage.
- It prevents you from entering into excessive risk situations.
There is a saying by professional investors: “The stock market is an expensive place to learn how to invest.” You have to be careful before diving into the trading world, and be sure to use all the tools at your disposal wisely.
We at Learn 2 Earn offer trading courses, taught by professional traders and experts, that will guide you through your trading journey and help you start trading confidently at the highest level. Check out our website for more information.