The terms risk management and money management are often used interchangeably, but they have distinct differences in trading and are an important part of effective portfolio management.
What are those differences? In this FXOpen article, we look at how understanding the concepts of money and risk management in trading can help you develop your strategies.
What Is Risk Management?
Trading assets always carries a certain level of risk, whether they are low-risk US treasuries or high-risk cryptocurrencies. The risk related to an asset class changes based on its characteristics, such as whether it’s a world reserve asset or an exotic currency with low trading volumes, as well as the market drivers affecting its value. Risk management involves analysing the potential losses you could experience from a trade against the potential profit and adopting approaches to minimising those losses, such as setting stop-loss levels.
Holding losing positions for too long is a common mistake for traders who do not have a robust risk/reward strategy in place. But appropriate risk management sets limits on position size and accepted downside moves so that you exit a losing position and preserve capital for profitable trades in the future.
The amount of acceptable volatility in an asset price will depend on the amount of personal risk tolerance your circumstances allow.
What Is Money Management?
What is the difference between money management and risk management in trading? Unlike risk management, money management refers to a trader’s overall strategy in allocating the capital they have available. This determines how much money to place in a trade, decides how to scale the position size up or down, and sets long-term trading goals.
A solid money management strategy sets aside sufficient capital to allow for inevitable mistakes and losses on positions, ensuring that each loss is small relative to the overall size of the portfolio. It also decides when to take profit on position and when to leave winning positions to run to maximise gains.
Risk Management Techniques
- Setting automatic orders. By placing a stop-loss order, you will exit a trade when the price reaches a specific level, preventing further losses when an asset moves against your expectations while taking profits to capture gains before the price turns around.
- Hedging. Offsetting a position with a negatively correlated asset that tends to move in the opposite direction means you can still make money even when the initial position goes against you.
- Diversifying. By allocating your money to different assets, markets, and timeframes, you can avoid heavy losses in a single area and maximise potential profits.
Money Management Techniques
- Risking money you can afford to lose. It is important to make unemotional trading decisions, which is less likely when you need the funds to pay for essentials.
- Limiting position size. As a rule, your average risk per trade should be no more than 2% of your account balance. In this way, you’ll still have funds available even after consecutive losses.
- Establishing a plan before starting. A well-defined trading plan that sets out entry and exit points and the amount to be risked will help you to avoid making impulsive decisions.
- Adjusting your strategy. A trading strategy that works for one type of asset may not work for another, so you will likely need to adopt different strategies over time depending on market conditions.
Metrics for Evaluating Risk Management in Trading
How do you measure the performance of the various risk management techniques?
By analysing the expected profit per trade compared with the amount of risk it involves, you can decide whether taking a position is a viable option. You can also measure one potential trade against another to find the trade with the highest potential. The ratio can vary, but in general, at least 1:3 (which denotes the prospect of earning $3 from a $1 loss) is considered acceptable.
You may set a limit for the maximum difference you are prepared to accept between your highest account value and the value after consecutive losses. For example, you can reverse a 10% drawdown with a gain of 11.1% to return to breakeven. However, a 50% drawdown would require subsequent gains of 100% just to break even. If your account exceeds the maximum drawdown, risk management rules would require closing trades to halt further losses.
The win/loss ratio measures the number of profitable trades compared with the number of unprofitable ones. A ratio above 1 indicates that at least 50% of the trades were profitable. You can use the win/loss ratio to calculate the risk-reward ratio. You can combine the two to understand how to improve your trading results by reducing your risk-reward ratio and increasing your win-loss ratio.
Metrics for Evaluating Money Management in Trading
How do you measure the success of your money management strategies?
Account Growth Rate
Consecutive gains can exponentially increase the value of your account, but a series of heavy losses will quickly eat into your balance. Analysing the increase in your account value over time will indicate the effectiveness of your trading strategies and dictate whether you need to make adjustments to protect your capital.
Average Risk Per Trade
Many traders determine the average risk they are prepared to take on each trade so that a single loss on a position accounts for only a small percentage of their account. The general rule is to limit the amount to be traded per trade to 1-2% of the account balance. For example, if you have a $1,000 portfolio, an average risk per trade of 2% would mean limiting trades to $20.
Money management and risk management are crucial to determining your long-term trading performance. By limiting your risk on each trade and managing your capital, you can avoid heavy losses and protect your portfolio. If you are ready to set up a trading portfolio, you can open an FXOpen account and get started with trading on the TickTrader platform.
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