What are the basic Money Management Rules in the trading business?

Published : 12 years ago, on 31/05/2012

Capital management or money management is one of the important aspects of a traders’ behaviour as it enables him/her to organise his portfolio in the right manner. Capital management rules can be defined as the base principles of trade which needs to be followed religiously, whether or not he/she is implementing any trading strategy, using any trading tool or have set a trade time.

Money management aims at developing a long term trading strategy. These rules are applied by the traders to protect their capital against losses. In order to sustain while trading in the market, the coherent atmosphere leading to profits is also related to these capital management rules so as to continually trade efficiently.

One of the important rules of money management is not to risk more than a small fraction into a single trade. Keeping only a small fraction can protect your account from getting depleted during the course of continuous losses in that particular account. Similarly, more the number of smaller account, better possibility of making profits in small portions.

There are ten basic rules of money management in trading:

1. Staying away from a losing position: This refers to averaging down into a long position (or simply up to a short position) which eventually leads your net capital to fall. However, on certain occasions, you may also get benefitted by averaging down to a certain position. Still the experts opt to keep away from such position for a long duration.
2. Not to get inundated with leveraging accounts: Most forex trading are done by acquiring a leveraged account. The experts always advise to avoid leverage as it creates an irreparable position for the trader.
3. Avoiding overtrade: Investors’ usually indulge in more than one trading business at one time. This can further increase one’s chances of losing big money.
4. Limiting Risks while trading: Risks can be associated with trading. However, it is also important to limit risks in order to sustain for a longer duration in the market. According to experts, one should expose their accounts to a maximum of a 5% risk while trading at a given point in time.
5. Usage of ‘stops’ and ‘targets’: The idea behind the introduction of stop loss and profit target is to help access the trader with a better understanding of his trading, and thus enabling him to attain profits at regular intervals.
6. Using ‘trailing stops’: This procedure creates an atmosphere for an investor to protect and lock-in his/her profits.
7. Always indulge in trades delivering a Risk-reward ratio of at least 1:2: Understanding this ratio of 1:2 is very important. It is the ratio of your profit target to your stop loss. Sometimes a trader would choose an R-R ratio of 1:3 which means losing out a trade three times to cancel profit. In other words, if one invests 600 pips in a trade (with an equivalent of 200 pips stop loss), it will in turn, require the investor to lose an equivalent of three trades to cancel profits.
8. Avoid trading during Sleep hours: Any trading done during sleep hours would have the least outcome as one cannot completely focus during sleep hours as he faces the least brain activity.  This would further result in delivering mistakes affecting money management.
9. Habit of compounding small profits over time: One should not trade with a mindset of making huge profits from the start. Perhaps, it is a good habit of compounding small profits attained through small trading positions over a period of time.
10. Application of matching instruments for a similar account. For example, if a currency pair is USDZAR and it uses a spread of 50 pips and a daily range of 1000 pips on a $1000 account results into a risky investment.