Basic Money Management in Trading

Money management is something that investors don’t really pay much attention to, as their goals are more long term and the only real concern as far as money management goes is being able to invest enough money.

Traders want to devote as much money as they can to their accounts as well, but money management in trading goes far beyond this. Trading involves playing a much more active role in managing one’s portfolios, which requires a more active approach to managing one’s account from a money management perspective.

Basic Money Management in TradingThere are several good reasons why money management is so important to managing a trading account successfully, and while discussions of money management can become quite advanced and mathematical, at a minimum one must understand the basics of money management in order to put oneself in a position to succeed, and especially to prevent or forestall failure.

Trading is really about seeking optimization in managing one’s account, which seeks not only the optimal return but the optimal return within the risk parameters that one needs to manage. Finding the balance between risk and reward, a crucial component of successful trading, falls upon proper money management to seek to accomplish.

It is not that money management is not important with investing, if one took a trading approach to investing that is, but if one is simply looking to hold long term positions and not really be concerned about how to actually maximize one’s returns or even manage one’s risk substantially, then one is not going to be so concerned about it.

Traders cannot afford such complacency though, as mistakes in trading are more and even much more magnified depending on one’s trading style and time frames, because traders trade much more often than investors do.

Trading and Trading Sizes

If the plan is to take a position and hold it for 10 or 20 years or longer, an investor really isn’t making any changes over this period by just holding. Apart from the initial decision of what to invest in, which of course should be made with sufficient deliberation and skill, there’s just nothing left to do but watch the value of the investment change.

There are traders who, on the other hand, turn over the value of their portfolio several times each and every trading day, and as positions are exited and new positions are entered, this requires that we manage the trading sizes of our trades appropriately.

Managing trade size is the most fundamental element of money management in trading. This is more complicated than just worrying about diversification with investments, which is in a sense a form of money management, as it at least looks to deflect some of the risk of one’s portfolio.

Trade size with trading determines both the risk and the opportunity size though, where the goal is to both avoid too small trade sizes or too little leverage, as well as too large trade sizes or too much leverage, when doing so would expose one to too much risk.

On the other hand, we want to make sure we’re not being too timid with our trade sizes relative to our trading account size, or we will underachieve, provided that we have the means to achieve that is.

Trading Size and Profitability

Trading is much more a game of skill than investing, as investing requires minimal or even no trade management, while trading is a much more involved affair, by nature. With more opportunities come more opportunities for mistakes, and there are several categories of mistakes that a trader can make.

One may trade with the incorrect size, one may select the wrong things to trade, one may enter and exit trades at the wrong time, and one may execute one’s trades improperly even when they have everything else figured out and one’s plan would otherwise be profitable.

One does not wonder or worry very much whether one is a profitable investor or not, as it is assumed that one’s ultimate profitability will be subject to the way that the investments perform, being subject more to luck than anything over the time period that the investments are held.

There is a certain probability that a given investment will be profitable over a certain period of time, whether that be 10 years, 30 years, or longer. Based upon past results, this probability will be assumed to be positive, to more likely make money than lose it, otherwise the investment would not really make sense. Whether or not this happens in a given instance is dependent upon the market mostly, but the market has tended to go up over the long run, and this is what the bet is mostly based upon.

As we shorten the time frame here, this will make the quality of one’s decisions more important, and the more frequently one trades, the more important this will become. Trading is like speeding up time in a sense, where one may experience a lifetime of trades that a typical investor may make in a month, a week, a day, or even in an hour or two.

Whether or not one’s trading becomes profitable or not will also depend far more on the skill of the trader, as by trading more frequently, one cannot just rely on mere luck, as the more one trades, the less luck has to do with it. It doesn’t take that much for luck to be evened out and the results becoming purely a reflection of the skill level of the trader.

This the same principle that can see a bad poker player beating a pro for a few hands, or for an hour perhaps, but the longer they play, the more the skill of the pro will have its say, to the point where if they play long enough the pro will win every time.

How profitable one may expect to be, based upon one’s trading skill, is the most important factor in trading, and it also influences the size and exposure that one should be subjecting oneself to when choosing trading sizes.

You Have To Be Profitable to Have Positive Expectations

If one is trading with a negative expectation, based upon one’s experiences in trading thus far, the goal needs to be to minimize one’s losses while still seeking to achieve to be profitable at some point.

Risk is a central theme in money management, and with a negative trading expectation, any trading at all may be seen as involving excessive risk. In order to learn to trade though, this requires trading of some sort, and newer traders are wise to consider simulated trading until they have at least learned enough to limit this risk to what is comfortable.

If and when one does decide to trade with real money without a track record of profitability, it is also wise to limit one’s sizes to limit the risk involved and preferably keep it to the point where one can continue to trade for as long as it takes to develop the proper skills to turn things around.

This can be challenging with trading some assets, as there are often minimal order sizes required, although forex trading or trading contracts for difference can provide all the flexibility that is required here, as one can trade as small as one wishes, even risking mere pennies per trade if one desires.

Ramping Up the Profits

While staying in the game and not exposing your account to excessive drawdowns is the most important goal in money management with trading, it is also important to leverage your skill appropriately.

One does not want to be subject to losing too much on any trade or any string of trades, and this is why professional traders generally limit their risk to 1-2% of their account on any given trade. You don’t want to limit yourself too much here either, or you will achieve less than you would if you weren’t unduly conservative.

How aggressive or conservative you are will depend again on what your expectation is, but skilled traders do want to seek to take advantage of this by ensuring that they are being rewarded for this in an acceptably safe manner.

This is really the crux of money management with trading, to pay all the regard to safety that you should, but not too much. If one has the requisite skills, this may mean some traders can leverage their trades by 10 or 20 times their investment, which allows them to multiply their gains, but only if they are good enough.

Less experienced traders try to do the same thing, and without a trading edge, without enough skill and experience, they end up accelerating not their progress but their decline.

With a wider variety of leverage options, traders do need to exercise much more caution, and the lesser one’s skill and experience is, the more caution is required and sensible. Many get involved in trading with wild ambitions and don’t properly understand that while these ambitions can be achieved, there is a lot involved in getting there and throwing caution to the wind with poor money management is not part of it.

As good rules of thumb, it is wise to ensure that one’s losses per trade are kept comfortable, as well as looking to adjust down appropriately if things aren’t going so well and the value of one’s account is moving in the wrong direction.

This means that whatever has resulted in a given loss over time requires some real changes, and while one of them is certainly the need to improve one’s trading, another need and perhaps a more glaring one is the need to reduce one’s average losses per trade, and reduce it enough.

Some of the world’s most successful traders have gone bust one or more times earlier in their careers, until they learned the lessons of proper money management in trading, and it’s better to learn these lessons first or at least before one experiences disaster.

Trading can involve successfully using a much more aggressive approach and achieving much better results than investors, but only if one is able, otherwise one’s results can be very impressive in a negative way, something no trader should ever want.

Andrew Liu


Andrew is passionate about anything related to finance, and provides readers with his keen insights into how the numbers add up and what they mean.

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