Money management techniques are broken down in to a couple of specific areas. The first is how much capital should a trader allocate to a trade, and the second is how much money a trader should be willing to lose on a particular trade. Prior to entering a trade, an investor should have a sound strategy for the profit and the loss that they are willing to accept, and the size of the bet they are willing to undertake.
In general, a prudent risk reward profile should be one where the profit is a multiple of the loss. For example, a trader would wants to earn $2 dollars for every $1 dollar of capital risked on a trade. In a scenario where a number of trades meet these criteria, a trader would need to win slightly more than 33.3% of the time to have a winning strategy. The math would work as follows on 9 trades: winning trades = (3 winners * $2 profit = $6 total profits), losing trades = (6 losers * $1 loss = $6 total loss). From this example, you can see that with 9 trades, the winners and the loser would cancel each other out, creating zero profit and loss. Slightly more than 33.3% would allow an investor to generate gains. If a trader did not have this type of mentality when looking at a trading methodology, over a period of time they will likely lose money. When entering into a trade, the trader most have a specific idea of where they would want to stop loss out of the trade, and where they would want to take profits on a trade.
Creating a stop loss
When a risk management strategy on a trade is employed, one of the first items an investor needs to consider is how much are they willing to risk on a trade based on capital allocated and a move in the financial instrument. When determining how much of a market swing are they willing to accept against the direction of their position, the trader needs to decide where they should stop loss out of a trade. The stop loss determines how much capital a trader is willing to risk on a trade. Stop losses can be based purely on a notional amount of money, such as risking $1 dollar, or a percent move in the market. A trader can look at historical moves or technical analysis to determine where a stop loss should be placed, or they can strictly base their decision on potential notional loses.
When a trader designs a trading strategy that has been historically back tested, the trader can back test numerous types of stop loss amounts to determine the optimal stop loss level. Support and resistance levels are very solid ways for trend line drawing traders and discretionary traders to determine a stop loss level. By using a trend line in the EUR/USD Weekly chart below, a trader who has decided to short the EUR/USD could place a stop loss in the market at a price slightly above the trend line resistance level near 1.51. If the market moved through this level, the trader could exit the position. Traders will also use technical indicators such as moving averages or horizontal trend lines to create a level in the market in which they would like to exit a position. The stop loss is a very important way to minimize losses and maximize gains.
Additionally, a trader could employ a stop loss that is dynamic and moves as the market moves. A trend following trader might consider creating a trailing stop loss that initially is set, and as the market moves up, the trailing stop loss moves up to a level that minimizes any draw downs created from adverse market moves. Trailing stop losses can be a function of a percent of a market movement or a specific dollar amount. Some traders use specific price action levels such as the low of a prior day when they are taking a long position and the high or a prior day when initiating a short position. There are many ways to optimize a trailing stop to maximize trades, and an investor should look at historical market movements on specific financial instruments to determine the best way to maximize gains relative to trialing stops.
Just as important as determining how much should be risked relative to a move in a financial instrument is the decision of where to exit a trade when taking profit. Just as with a stop loss, a trader in advance should determine based on the risk associated with a loss, where they should take a profit. Similar to a stop loss, a take profit level can be based on a notional amount of dollars, a percent move in the market, or a specific technical level. Support and resistance levels are excellent ways to create a take profit level. When determining the take profit, it is also important to combine the amount you are looking to gain on the trade, with the amount you are willing to risk, which is your stop loss. Traders should avoid placing trades where they are willing to risk a greater amount of capital, than they are looking to gain. A trailing stop loss is one way traders can take profit on a trade.