Top 4 Money Management Mistakes When Trading
Money management is an important skill for traders of all levels, from novices to experienced professionals. It can help traders manage risk, enhance returns, optimize performance, and, most importantly, stay disciplined.
An essential part of overall risk management, money management done properly can help you to maximize profits and minimize losses, which should be your fundamental goal. No matter what style of trader you are, you are aiming for long-term consistency.
What Is Money Management?
Money management for traders means making decisions about how much money to place on a trade and how to manage the risks associated with trading. As part of a trading plan, which has fixed steps as to when and how to enter and exit a trade, money management concentrates on ‘how much”, as in the question ‘how much am I willing to lose?’
By setting clear rules for this “how much”, traders can ensure that they are avoiding impulsive decisions. However, there are many instances of traders not applying their own rules and here we look at four common mistakes and how to avoid them.
You Don’t Set a Maximum Loss per Trade
This is the most common mistake for beginner traders. Needless to say, this should be done before your entry: it is extremely difficult to decide “enough is enough” in the middle of a fast moving market.
The obvious solution is to use stop loss orders. Without a stop loss, you may hold onto a losing trade or, worse, be unable to get out of a losing position. This is a basic order type which is extremely useful for short timeframe traders, such as day traders, and they are executed when a stock price reaches a specified price.
You Put Too Much on a Single Trade
This should be obvious, but for some traders, as noted below, there are times when it is not. There are many ways to calculate how much is too much. For new traders, one of the simplest and most common is the 2% rule.
According to this rule, a trader should only risk up to 2% of their total capital on any given trade (taking into account brokerage fees and so on). Some prefer a 1% rule, others more than 2. It can be any percentage but the important thing is to stick to it. This is known as the fixed percent model and there are other types you can use. It depends on your trading style and what you are comfortable with. It also depends on whether you are using leverage and margin when trading.
You Don’t Use or Understand Risk/Reward Ratios
This is a central pillar for money management in trading. This ratio helps traders decide whether the risks that need to be undertaken in any trade are worth the potential profits on offer.
Ultimately, the risk/reward ratio is also linked to win rates. Over a long period, if you win, or calculate on winning, a certain percentage of trades, your risk/reward must reflect this percentage.
You Change Your Money Management To Suit Market Conditions or Previous Successes
When you’re on a winning streak and you’re convinced that your strategy is working exceptionally well, it’s certainly tempting to up the ante and put more of your capital into play.
Avoiding acting on this impulse is difficult. Following your greed is definitely not sound money management. A money management strategy is there to bring you long-term profitability and the real impact of these changes will be seen in the long term.
This is an important point. Money management is an art that will protect you from a series of (inevitable) losses, or a very large loss. But in many ways it is there to limit not only losses but also psychological excesses in trading.