I am constantly amazed by the fact that many intelligent and experienced traders, armed with good trading strategies, often overlook, disregard, or belittle the importance of good money management in trading. In recent months, some of them have sustained huge losses because of this oversight.

Good money management is about optimizing the sizes of our trades, so that we can effectively control the risk exposure of our trading accounts. This is how we limit our losses when the trading strategy gives us losing trades (which will happen, sometimes even consecutively!)

In view of this, a myth often quoted among traders who emphasize the importance of money management is that “even a bad trading strategy can make money with good money management”. People who subscribe to this statement essentially downplay the importance of a good trading method and excessively attribute trading success to good money management.

The truth of the matter is that if you don’t have a good trading method that gives you an edge over other market participants, good money management will not make you profitable; all it will do for you is to ensure you lose money more “systematically” and slowly!

Without an edge over the market, you’re just like a gambler visiting a casino, where the house always has an edge (a mathematical advantage) over you. In such a scenario, the longer you stay in the market, the more certain it is that you will lose all your money eventually. In fact, if you don’t have a method that gives you an edge, the only way you could make money is to practise extremely bad money management, i.e. by putting all your stakes on one or a few trades, hoping that “luck” would strike in your favor for a very brief period of time and make you profit big-time, and then leaving the market immediately thereafter! (This is essentially what all gamblers are pinning their futile hopes on!)

The right way to understand the role of good money management is seen in a slight variation of the first statement: “Even a good trading strategy can lose money with bad money management”.

To win consistently in the market, we need

1) A method that gives you an edge (an advantage) over the market
2) Good money management to limit your risk when there are losing trades
3) Discipline and good emotional control to implement the above despite the often unnerving market fluctuations

If 10 traders are armed with the same powerful trading strategy, one of the most important things that distinguishes the successful traders from the unsuccessful is their money management in trading.

Money management is concerned with how you systematically decide how many lots to trade in any single trade. This decision must not be based on impulse or instincts or emotions! If it is, you will find yourself exposed to a deadly risk of ruin.

Sometimes we hear of a trader who, after making a huge killing based on a fluke, feel so emotionally charged-up and confident that he decides to place a large position in his next trade, exposing his trading account to obscene risk. Trading like this means it’s just a matter of time before huge losses dwarf the wins, and the trader is devastated emotionally and financially.

When placing a trade, I always ask myself: how many percent of my account am I prepared to lose if I get stopped out of this trade?

As a rule, I risk no more than 3 % of my account size in any one trade.

For example, my trading account is now $20,000. This means that if the stop-loss for this trade is triggered, I am prepared to lose 3% of $20,000 = $600.

If my stop-loss is 30 pips, and the $value per pip is $10, then the number of lots I place for this trade is

$600 divided by 30, and then divided by 10 => 2 lots!

In this way, I systematically decide how many lots I trade, based on the Stop-loss level of my trading strategy, and also based on my existing account size. Such a decision must never be based on how good or confident you feel, i.e. you must not suddenly decide to trade 10 lots just because you feel very confident.  Rather, money management is always based on

1)     How many percent of your account you are prepared to risk per trade

2)     Current account size

3)     Stop-loss level (how many pips away from entry price)

Strictly maintaining this discipline has served me very well and helped me compound my trading account several times over!

Every trader must guard himself against the drawdown, which refers to the percentage drop in his account size after one losing trade or consecutive losing trades.

For example, imagine that after losing a few trades in a row, your $20,000 account is reduced to $12,000; that would be a drawdown of 8,000/20,000 = 40%.

If I were to ask some new traders, “In order to be back up to $20,000, what percentage return do you need to generate?”, many would answer, “Since I lost 40%, I have to make back 40%!”

This couldn’t be more wrong! Note that after losing 40%, the trader now starts with a lower base, i.e. to undo the $8,000 loss, the return he needs to generate is 8,000/12,000 = 67%!

The more severe the drawdown, the harder it becomes to undo the damage, as shown in the attached chart.

A severe drawdown causes you to have to start with a much smaller base, thereby having to take higher risks to undo the damage. This is why many undisciplined traders, who do not systematically plan their trade sizes, find themselves going into a “downward spiral” when they suffer severe losses.

This is why I risk no more than 3 % of my account size per trade. In fact, new traders might want to risk no more than 1.5% to 2 % of the account size in any one trade. Sometimes, even with good trading strategies, you might suffer 3 or 4 consecutive losses. You need to ensure that the emotional impact of the resulting drawdown doesn’t damage you too much, so that you can recover (emotionally and financially) from the losing streak. This cannot be over-emphasized, for it distinguishes the profitable traders from the losing ones!