Money Management Rules: Guidelines to Maximizing Your Gains and Minimizing Losses

George Soros, one of the greatest traders of our time, said there are two important rules to trading:

Rule #1: Don’t Lose Money
 
Rule #2: Look up rule number one

George Soros, one of the greatest traders of our time, said there are two important rules to trading:

 

Rule #1: Don’t Lose Money
 
Rule #2: Look up rule number one

 

What separates professional traders from novice traders is that professionals have a system of managing money and risk control. Traders must understand that money in the account is just like inventory for the store owner; empty shelves will not attract customers or generate sales, just like an empty trading account is useless, because trader cannot place trades.

 

There are certain rules and guidelines that a trader must follow when he or she creating and implementing a successful money management plan. In trading it’s important to understand that in order to be successful and consistent, profits must always be larger than losses. It’s a very obvious rule, but most traders see large losses and small gains in their accounts due to lack of money management rules.

 

Following are the rules that are used and implemented by successful traders over the past 200 years.

 

Money Management Rule #1

Always establish protective stops, never trade in the market with potentially unlimited loss.

 

Trading is about setups and probabilities; it is based on the rules that what happened in the past will most likely repeat itself in the future. However nothing is ever 100 percent accurate, especially in the market. That is why it’s important to control risk and save capital by placing protective stops.

 

Money Management Rule #2

Never average a losing position. Never send good money after bad.

 

One of the worst mistakes a trader can make is to average a loss. Having a loss on a trade means that the trader is wrong, so why add to a losing position, the best way to handle a losing position is to close the trade and look for a better trading setup. Trader must save capital for a better trade. 

 

Money Management Rule #3

Never risk more than 10% of the account at any given time during a trading period. Always keep the other 90% of the capital in reserve.

 

Trading is not gambling, but is very often confused with gambling by those who do not participate in the markets and think that markets are nothing but a giant casino. No trader is right all of the time, there are periods of great gains and periods of losses. It’s important that the trader does not risk more than 10% of his or her capital at any given time, because if a trader loses 10% it takes an 11% gain to make it back. However if trader looses 50% of his or her capital it takes a 100% gain to bring the account to the original balance. 

 

Money Management Rule #4

After establishing 10% rule for the account, subdivide the 10% into probing trades.

 

A trader must never enter with a large position on the unproven trade. In order to find a successful trade trader must probe the market in order to seek out the trade that works. The best way is to subdivide the 10% into 10 to 20 potential probing trades, however if a trader failed to find a successful trade after 6 to 8 failed trades, most likely the trading strategy is not conforming with the market and its best to wait on the sidelines for the next potential trade to surface.

 

Money Management Rule #5

Always establish a positive risk reward ratio for the trade.

 

A trader must have a trade where a potential gain is larger than a potential loss. A positive risk reward will insure that the trader will be profitable in a long run as long as he or she follows this rule. However if a trader places a trade where risk is higher than the reward than he or she will lose his or her trading stake over a period of time, because it takes a higher number of successful trades just to make back the loss and to bring the account to the original balance.

 

Guidelines for establishing Risk/Reward Ratio:

 

Risk/Reward ratio will be deferent for each individual trader and is usually based on trading style and strategy.

 

Day Trader: Ratio 1:2 and 1:3

Time in trade: intraday trade 10 minutes to 4 hours

 

For every unit of risk trader must gain between 2 to 3 units of reward, higher ratio is possible but very uncommon and can lead to a ruined position if the trader “overholds” the position 

 

Positive: Small stops due to the lower time frames and small intraday swings, most brokers will give reduced margin for non-FX market.

 

Negative: Almost impossible to achieve high risk/reward ratios, a high number of failed trades to an increased number of trading setups.

 

Swing Trader: Ratio between 1:3 and 1:5

Time in trade: intraweek trade 2 to 4 days, rarely over the weekend

 

For every unit of risk trader must gain between 3 to 5 units of reward, higher ratio is possible but rare due to time and target limitations.

 

Positive: Higher gains on trades due to the increased timeframe and holding period, lower number of failed trades due to less frequent trading setups.

 

Negative: increased volatility, overnight gaps for non 24 hour markets, larger capital requirements

 

Position Trader: Ratio between 1:6 and 1:10

Time in trade: trade can last anywhere from 2 weeks to 6 months

 

For every unit of risk trader must gain between 6 to 10 units of reward, higher ratio is possible and is common due to the time it takes trade to develop.

 

Positive: Higher gains on trades due to the increased timeframe and holding period, lowest number of failed trades due to less frequent trading setups.

 

Negative: increased volatility, overnight gaps for non 24 hour markets, largest capital requirements, and large stops required in order to capture a significant move. Fewest potential setups available, traders can be out of the market for months at a time due to the lack of trading setups.

 

These rules are basic guidelines for both mature and novice traders alike, the only separation between mature traders and novices is ones follow these rules and the others don’t.

 

Good luck trading and never forget the two rules stated in the beginning of the article.