Money management – protecting your capital

Money management is a concept that protects your trading capital from losing trades and it is the most important skill for trading. This lesson will demonstrate the importance of applying prudent risk management to avoid large losses that can lead to you losing your entire trading account.

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Money management preserves your trading capital

Money management high risk more than 2 per cent

Money management, also called risk management, is a core concept that you should start with immediately when you begin to learn and it should be the very core focus throughout your trading career. It will allow you to deal with performance downturns and it will preserve your trading account during these times, enabling you to carry on trading.

The core principle of money management is that you should only ever risk a very small portion of the money that you have to trade with on any single trade.

Many professional traders do not advocate risking any more than 1% to 2% of an account on a single trade.

Money management low risk 2 percent

Limiting your risk per trade to a maximum of 1-2% of your whole account greatly reduces the effect of losing streaks, as you will preserve the majority of your trading account.

Risking only 1% on each trade means you can lose twenty trades in a row and still retain over 80% of your starting capital. If you were to risk 5% per trade, after twenty losing trades there would be less than 40% of your original starting capital left.

The table below shows you the effects of only risking 1% or less on each trade against risking 5%:

TradeAccount1% RiskTradeAccount5% Risk
1$20,000$2001$20,000$1,000
2$19,800$1982$19,000$950
3$19,602$1963$18,050$903
4$19,406$1944$17,148$857
5$19,212$1925$16,290$815
6$19,020$1906$15,476$774
7$18,830$1887$14,702$735
8$18,641$1868$13,967$698
9$18,455$1859$13,268$663
10$18,270$18310$12,605$630
11$18,088$18111$11,975$599
12$17,907$17912$11,376$569
13$17,728$17713$10,807$540
14$17,550$17614$10,267$513
15$17,375$17415$9,753$488
16$17,201$17216$9,266$463
17$17,029$17017$8,803$440
18$16,859$16918$8,362$418
19$16,690$16719$7,944$397
20$16,523$16520$7,547$377

After losing twenty trades, the account is reduced to $16,523 after risking only 1% on each trade; risking 5%, the account balance is reduced to $7,547.

After twenty trades, by risking 5% on each trade, the trader now has to make over 100% of the account just to get back to the original starting capital.

Simply by adhering to risk management, an account can survive longer drawdown periods and still be able to trade.

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The risk reward ratio ensure that you gain more than you lose

The risk to reward ratio is how much capital a trader is willing to risk in order to gain the potential reward on the trade. You can use either a monetary value or pip value when calculating the risk to reward.

For example, if you are risking $1 to potentially make $2, the reward is divided by the risk and so the risk to reward ratio is 1:2. If you are risking 30 pips on a trade and have a 300 pip profit target, the risk to reward ratio is 1:10.

When looking to take a trade, you should always make sure that your potential reward is larger than your potential loss.

The following chart shows you a real example of how this may look. The chart shows the stop loss, shown as sl1, the entry, shown as el2 and the profit target shown as tp3.

The distance between the stop loss and entry, shown as number_4 is 40.4 pips away. The distance between the entry and the profit target, shown as number_5 is 88 pips away. This means that the risk to reward is over 1:2 for this trade.

Real example of risk to reward

sl1 Stop loss
el2 Entry
tp3 Profit target
number_4 Distance between entry and stop loss is 40.4 pips
number_5 Distance between entry and profit target is 88 pips

Know where your stop loss and profit target is before you trade

Protecting your account with a stop loss

Any time you consider entering into a trade, you should not only have pre-determined where your entry will be, you should also have pre-determined where your stop loss and profit target will be.

Once you know where your stop loss and entry point is, you can calculate the risk and potential profit on the trade.

As a general rule of thumb, you should aim for a risk reward ratio of 1:2 or better. If you maintain a risk to reward ratio of 1:2 then you only need one-third of your the trades to win to remain break even.

The risk reward ratio is closely connected to the percentage of your trades that end up winning. The risk reward ratio itself does not automatically mean success. Even a risk reward ratio of 1:4 does not help you if less than 20% of your trades end with a profit. So the risk reward ratio has to be seen as an aspect of an overall trading strategy, and not in isolation.

A great way to improve your effective risk reward ratio is using trailing stops, as they will make sure that in many trades that end of losing, your are losing less than the amount originally set for your stop loss.

Summary

So far, you have learned that ...

  • ... money management is the most important skill a trader can have.
  • ... using money management will protect your account in the event of a performance downturn and you will keep the ability to trade.
  • ... you should never risk more than 1% to 2% of your account on any single trade.
  • ... by only risking 1%, you can have 20 losing trades in a row and still retain over 80% of your account.
  • ... you should always stick to a risk to reward ratio of at least 1:2 and ideally have a risk to reward ratio of 1:3.
  • ... risk to reward ratio is calculated by dividing your profit target by your stop loss.

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  • is the 1:3 ratio at pending sell/buy stop, I assume if you are effectively managing your trade by adjusting your stop loss that the ratio will be less?
  • Hey bobbywelsh,

    Are you referring to the beginner strategy?

    In the lesson above, when we refer to 1:3 ratios, we are talking about a fixed stop loss. The beginner strategy makes use of trailing stop losses, because you adjust the stop in the direction of the trade.

    So because you have a dynamic risk to reward, the ratio will be less indeed.

    However, bear in mind that different strategies use different risk to reward ratios. Some have fixed and other have dynamic.
  • Thanks Dean, Have found how to work the site a bit better smile
    Yes I was refering to the beginner strategy, I assume that is dynamic (trailing stop losses?)
    I was thinking does that not mean that you would have more trades being prematurely closed as it reaches stop loss more readily as the level has been reduced - ie it may be more likely to reach the new stop loss (but not the old one) before meeting the profit level therefore stoppinf the trade at a loss (albeit a smaller than original loss but a loss all the same)?
  • Hi bobbywelsh,

    if you follow a strategy and are kicked out of a trade by SL, that does not mean that your trade is closed prematurely. It is closed, because according to the strategy it should be closed. The price hit your SL level (that you set according to rules of the strategy) and it´s absolutely fine to close the position because following those rules will make the strategy profitable in the longterm - that´s what you want from a good strategy. smile

    If you move your SL, you increase your profits by lowering your potential losses -> the RRR improves in your favor. Yes, sometimes it may happen that the price reaches new stop loss but not the old one. However, you don´t mind it because you know that in the longterm you´re saving money.

    Btw, being kicked out by SL doesn´t necessarily mean that the trade is a loser, very often you move your SL above your entry price and take profit even though the SL has been activated. wink
  • Thanks MBranjo, never though that the SL would be above the entry price... that makes sense.
  • Hi bobby,

    you´re welcome! Yes of course, whilst you are in the trade you should manage it and if new fractals appear above an entry price, you move your SL there. wink

    If you have more questions, feel free to ask.
  • Hi friend.
    This is great site, this year I will try to teach everithing and start treadind demo and real maybe. Good Luck and management.
  • If when using the s/l and t/p figures in line with the beginner strategy and we find that the risk reward ratio isn't 1:1 min should we be using some discretion and maybe not open a pending order? Or would we rather move the t/p up to the next pivot point? In a situation for example where even using trailing stops might not give the correct ratio by the end of the trade.

    I realise that more experienced traders will have different rules and systems, but I'm more referring to someone just following the beginner strategy for the time being.

    Thanks
  • that is very good suggestion
  • I like this concept it is very good
  • Can we set trailing SL in Varengold MT4?
  • vichooos:
    Can we set trailing SL in Varengold MT4?

    Hi Vichooos,

    Yes you can set a trailing stop on the Varengold mt4.
    You can do this by right clicking on the open order select trailing stop and choose a distance.

    Regards,
    Timothy
  • I noticed that we may use trailing SL. do we change our profit target when position opened?
    Thanks.
  • Hi JHTAN,

    This depends on your personal preferences. But usually people let their profit target stay in place and start locking in profit with the trailing stop loss.

    Regards,
    Timothy
  • Hello guys,

    One more Q.
    If we have set trailing S/L to a trade, and then switch off the system giving the trade some time, Will it(trailing S/L) be active or should MT4 be open for that?

    Reg
    V
  • Hi vichooos,
    Important question. Trailing stops are maintained on your platform. They become hard stops when MT4 is closed. If you want to take advantage of them you will need to keep it on!
    Regards.
    Peter
  • Got it.
    Thanks a ton Peter, it is such a relief that there is a bunch of guys here who are ready to answer all our doubts. That's the best thing about Tradimo.
  • Hi hindsighthero,
    Wow what a great site you have here, thanks for running it.
    Is there an API to plugin to this site so that I could manage my ratio dynamically?
    BR,
    Johan
  • Hi Johan,
    I am glad you like the site. Can you please elaborate a bit more about what sort of a RR managing tool you refer to? Would that be for Metatrader or a specific webtrader?
    Let me know!
    Regards.
    Peter

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