Why is money management so important? Put simply it is the ability to determine your trade size in relation to your overall portfolio position, and takes into account open positions and cash in hand.
Imagine you are just starting out and have your cash ready and waiting, and let us suppose it's ?10,000. How much are you going to put on your first trade 5%, 10%, 20%, or all of it? Do you consult your partner, your friends, or just see how you feel when you place the trade. Many traders, in fact probably most, have no idea about trade size, how to work it out logically, or even whether it is important. The problem of course (as ever) is that it is rather a dull subject, and one which requires discipline and attention to detail
One other point, before we move on, is that everything is based on percentages, for the simple reason that they can be applied to any amount of money irrespectively. If you lose 100% of your money you are out of the game. If you lose ?100, how much does this represent of your starting capital? From now on we work in percentages which can be applied to any amount in any currency.
Let us start with a very simple example, and assume that you have never traded before. You therefore have 100% trading capital. If we are prepared to risk 50% of our capital per trade, how many trades could we get wrong before we were out of the game? The answer of course is two, which does not seem very sensible, unless you are a gambler or simply trading for the thrill of losing money! So, how much should you start with on your first trade? Most articles written on the subject suggest that this is 2%. I suggest that you start with a maximum of 1%. This means that you can get 100 trades wrong before you are out of the game. I know this seems unlikely but anything can happen, and bear in mind that even with the best trading system in the world you are probably not going to do better than 60% success rate, or 6 in 10 trades going into profit.
OK, so now we have established that to start we are only going to risk a maximum of 1% of our trading capital on each trade. The next question is how much of our trading capital do we want to risk in total at any one time? Imagine if you had converted all your trading capital into open positions on the market and there was a world event which sent prices tumbling. How much of your capital could you afford to lose in one such event and still recover? If we lost 5%, we could recover as this only requires a recovery of 5.2%, similarly a 10% loss only requires a recovery of 11.1%. Both of these are achievable but anything more is going to be difficult. Some commentators suggest risking between 6% and 15% of our trading capital at any one time. Again, I am conservative and I suggest that you start with a maximum of 10%. This means that if the worst happens and there is a collapse in prices the most you would lose is 10% of your working capital.
Please note that both the figures suggested are maximum percentages. If you want to keep it to less this is fine, as long as you remember where the maximum level is set. The key to success is combining your money management with good risk management tools, the simplest of which is the stop loss. Using good money management with simple risk management tools will preserve your capital and keep you in the game, to live another day. Ignore them, and you will lose all your money ? very quickly.