A trader should apply appropriate money management strategies to ensure their long term survival in the trading world.
There are traders who make 20 or 30 profitable trades in a row but still end up losing money.
A single disastrous loss can easily wipe up your long series of profitable trades and tear into your capital.
A general rule of thumb is to limit your losses to a maximum of 2% of your trading capital per trade.
This is commonly known as the 2% Money Management Strategies.
The 2% Money Management Strategy state that the maximum risk that you can afford to lose on any trade is 2% of your trading account.
This means that if you have a trading account of $25,000, you may risk up to $500 (2% of $25,000) on any individual trade. However, do note that this doesn’t mean you can only buy $500 worth of stock. It means that you can only afford to lose $500 from any individual trade.
So in effect this strategy force you to have the discipline to think through your stop loss level even before you ever put on a trade.
Let’s look at an illustrative below to show how this strategy work.
Example : You have a trading account of $50,000 and want to buy stock of MCD which is currently trading at $60. Base on your analysis, you have set the profit target at $68 and the stop loss limit at $56. What is the number of MCD stocks you can buy if you are to apply the 2% money management strategy? Commission is assume to be $30.
Risk Amount = Account size * 2% = $50,000 * 2 % = $1,000
Remember, the risk amount of $1,000 is inclusive of commission and slippage. Now that you know the amount you may risk on your trade ($1,000) you are able to calculate your proper trade size.
Trade Size = (Risk Amount – Commission) / (Entry Price – Stop Loss)
= ($1,000 - $30) / ($60 - $56) = 242 shares.
Base on the 2% strategy, you should be able to buy 242 MCD shares. Take note that if you are buying 242 shares of MCD, the amount of capital invested will be $14,520 ($60 * 242). You may risk less than 2% per trade but not more than that. Therefore it is recommended to round the trade size to 200 shares or lower.
Measure your account size at the beginning of the month. This would include cash and cash equivalent in your trading account and today’s market value of all your open trade.
If your beginning account is $50,000, the 2% strategy allows you to risk about $1,000 per trade.
If you have a profitable month and the account size grows to $54,000, your risk per trade for the next month can be increased to $1,080 (2% * $54,000).
However if you have a bad month and the account drop to $45,000, you can only risk $$900 (2% * $45,000) per trade in the following month.
For every trade that you are entering, recognize the correct stop loss exit based on market dynamics. After that, adjust your trade size to manage your dollar loss. Do not get it the other way around.
If you stick by the 2% strategy, it will takes at least 50 losing trades in a roll to wipe out your entire account. This will enable you to survived in the inevitable drawdown, review your trading system, learn how to trade through live experience and eventually generating a consistent profit.