Money Management / Risk Management

A crucial aspect of day trading

Money management, also referred to as “risk management, is absolutely critical to successful day trading on an ongoing basis. Many traders regard it as the single most important aspect of trading. Indeed, lack of proper money management is a major cause of failure among new traders. There is little doubt that practicing good money management will lead to more traders being able to achieve success, or to avoid devastating failures.
Capital Preservation is the Goal

One of the main ideas behind money management is to preserve capital so as to enable one to live to trade another day. Before you ever enter a trade, the first thing you should ask yourself is how much money am I risking here and can I afford to lose it? One of the most common mistakes new day traders make is that of “risking the whole wad” on one or two stocks. There is not a quicker way to face disastrous results than engaging in this practice. Bearing too much risk in trying to secure a huge win in a single stock isn’t worth it, if the risk can knock you out of the trading game due to a very large loss of capital. Attempting to get the big win may be exhilarating, but failure in the attempt can wipe you out.

The 2% Rule of Thumb

There is a so-called “rule of thumb” in the day trading world which states that you shouldn’t risk more than 2% of your total trading capital on any one trade. Doing so ensures you can make many bad trades and still not be knocked out of the game. Despite this general rule of thumb, many traders will define their maximum risk tolerance level differently. By risking under 2%, you can afford to be indifferent to any individual trade. Keeping your risk small and constant is absolutely critical. The idea here is that no one trade is going to significantly affect you if it results in a loss. If a trade goes against you, you are not going to go broke, or have to sell your house, car, art and jewelry in order to continue trading.

The way to define risk for purposes of the 2% rule is by determining the loss you will incur if the stock price goes down. For example, if you own 1000 shares of XYZ at $100 with a $2 stop loss order in place, your risk is: $2 * 1000 = $2,000. So long as you have capital amounting to at least $100,000 on hand, you would not be considered to be in breach of this “rule”.

Cut Losses, Let Profits Run

There is an old investing adage about cutting ones losses and letting profits run. What this means is that you should strive to keep your losses manageable, and ensure that no single trade does too much damage. The thinking here is that if you keep the losses small, the profits will take care of themselves. In the case of profits, you can exit the position once you have determined that you have earned a sufficiently “large” enough amount. But, what exactly is a small loss? What’s a large enough profit? There is no one answer, and what is right for one trader will not necessarily be right for another.