Every beginner trader, when choosing a perfect money management approach, can be lost in their variety at first. All these approaches are different from one another, which means their purposes vary. Some of them allow market players to yield substantial profits, while others are aimed at minimizing losses. In order to find a perfect approach, traders should consider acceptable profits and losses and then they can analyze the approaches that comply with their requests.
Notably, beginners rarely make the right decision on their first attempt. Testing and comparing several techniques will surely help traders find the proper strategy (maybe even more than one) that will enhance their confidence in the market. Now that you are aware of all the pitfalls that await novice traders when choosing the ideal approach, let us look at the most popular capital management strategies.
Distribution of profits and losses. Using this approach, a trader should regularly compare profits with losses from a successful trade. In fact, a trader should find the correlation between "pluses" and "minuses" when conducting all transactions: after every single trading day, week, month, quarter, and year. The approach seems to be as easy as pie, but not for everyone. As a rule, beginners face challenges at the stage of comparing profits and losses. If they are lucky, they may find an equal distribution of successful and failed trades so that they can avoid losses. Notably, losses often exceed profits at the start.
In order to smooth over this factor, experts recommend using the golden rule of money management: the profit potential of a trade should be 1.5 times greater than the risk. Beginner traders using scalping should withdraw their profit from a trading account from time to time. In case of a few failed trades, this will help a trader avoid risks of losing all the capital. If a market player prefers using a conservative strategy, the profit can remain in the account so that one can increase the trade volume as well as the capital.
Mathematical expectation. Not all novice traders know that the predominance of profitable trades does not guarantee that they do not incur losses. A successful trader should always calculate average profits and losses and strive for a profit value to always exceed a loss value at the same time. The approach based on constant striving for a positive result is called the mathematical expectation and is calculated using the following formula: PW*SW – PL*SL = MO. In this case, PW is the probability of profit and PL is the probability of loss. SW means the average profit per trade, while SL is the average loss per trade. By solving this equation, there is the mathematical expectation (MO).
At the first glance, it seems to be a difficult process, but the key here is to understand two values of the mathematical expectation. A positive result guarantees that your trading tactics at the chosen stage will be profitable. Conversely, the negative or zero MO will produce an opposite result. That is why beginners should avoid risks and choose only positive values. An accurate determination of both potential profits and losses can help traders avoid failures. To do so, they should carefully analyze their own trades or any other real story.
Deposit split. This is the most easy-to-understand money management method. The essence of this approach is that a trader must not deposit all the funds in the brokerage account under any circumstances. Importantly, no trading platform guarantees the force majeure protection. There are always risks of account reset. That is why a trader should have the so-called strategic spare money. These will be the trader’s rainy day funds in case risks are realized. Hedging. This approach employs opening opposite trades in any asset or financial instrument in different but economically related markets. Simply put, traders can open positions in one market to offset risks of a reverse transaction in another market. Hedging is often called the trader’s insurance. This approach is used in money management to minimize losses given the circumstances. Thus, in case of pessimistic forecasts, a market player can not only recover losses in one trade, but also yield profits in another one.
Margin reduction. In order to understand the essence of this approach, the knowledge of the margin in trading is required. Supposedly, you have some funds in your account. When you open a trade, these funds are reserved by a broker in order to compensate for possible losses. This is what the margin is. All you should know is its limit. In traditional money management, the margin should not exceed 15-20% of the total capital. In this case, risks will be minimal even during sharp price fluctuations.
Stop Loss. The order that limits losses is oftentimes undeservingly ignored. Beginner traders can simply not know about all the benefits of a Stop Loss and therefore can unknowingly put their deposit at risk. As for experienced traders, they sometimes intentionally move the order under the influence of strong feelings and hoping for a successful outcome. It seems to them that the expansion of losses will eventually stop and the price will go in the right direction. However, such blind confidence usually ends in a loss of funds.
Under the market rule, a Stop Loss is a must do. There are two simple reasons why. Firstly, Stop orders help traders avoid unnecessary emotional involvement. Secondly, a Stop Loss allows market players to manage their trading risks if the price moves in the direction contrary to expectations. Thus, there is always a chance to close a losing trade with a Stop Loss set in advance.
Diversification. Financial experts call this approach "Don't put your eggs in one basket". Following this rule, traders should not invest all their money in one asset. The biggest part of the capital should be either spent on a variety of financial instruments or saved. A good example of diversification is the use of gold along with other assets. When one of the leading world currencies tumbles, the precious metal increases in value.
Notably, this approach does not suit speculators trading intraday, unlike investors who have enough time to analyze the state of the market to assess emitters and their asset prices. An investment portfolio should be diversified so that losses on one asset are offset by profits on another one. According to experts, a stable portfolio should be diversified equally in the following way: it should contain 1/3 shares of state-owned companies and large corporations, the same amount of shares of fastest-growing firms, as well as average-risk companies.
Risk limiting. Experienced market players advise traders that they use this approach when developing a trading strategy, that is, when they take their first steps in trading. At the initial stage, it is very important to determine the level of losses you can actually sustain on a trade. This level is set as a percentage of the deposit amount. It may vary depending on the amount of funds in the account and the trading strategy used. For example, an experienced trader has a substantial capital and follows a conservative strategy. In this case, the risk limit is 10-15%. Meanwhile, if it is a beginner trader with a $100-200 deposit, the risk limit per trade will be 2-5%.
Summing up, we would like to focus on the fact that traders othen use several money management approaches. Numerous examples show how a combination of well-chosen methods can turn a losing trading strategy into a profitable one. You should always keep in mind that the most important thing is the relevance of the approach. Effective and competent account management always depends on the right choice of a trading instrument.
Notably, beginners rarely make the right decision on their first attempt. Testing and comparing several techniques will surely help traders find the proper strategy (maybe even more than one) that will enhance their confidence in the market. Now that you are aware of all the pitfalls that await novice traders when choosing the ideal approach, let us look at the most popular capital management strategies.
Distribution of profits and losses. Using this approach, a trader should regularly compare profits with losses from a successful trade. In fact, a trader should find the correlation between "pluses" and "minuses" when conducting all transactions: after every single trading day, week, month, quarter, and year. The approach seems to be as easy as pie, but not for everyone. As a rule, beginners face challenges at the stage of comparing profits and losses. If they are lucky, they may find an equal distribution of successful and failed trades so that they can avoid losses. Notably, losses often exceed profits at the start.
In order to smooth over this factor, experts recommend using the golden rule of money management: the profit potential of a trade should be 1.5 times greater than the risk. Beginner traders using scalping should withdraw their profit from a trading account from time to time. In case of a few failed trades, this will help a trader avoid risks of losing all the capital. If a market player prefers using a conservative strategy, the profit can remain in the account so that one can increase the trade volume as well as the capital.
Mathematical expectation. Not all novice traders know that the predominance of profitable trades does not guarantee that they do not incur losses. A successful trader should always calculate average profits and losses and strive for a profit value to always exceed a loss value at the same time. The approach based on constant striving for a positive result is called the mathematical expectation and is calculated using the following formula: PW*SW – PL*SL = MO. In this case, PW is the probability of profit and PL is the probability of loss. SW means the average profit per trade, while SL is the average loss per trade. By solving this equation, there is the mathematical expectation (MO).
At the first glance, it seems to be a difficult process, but the key here is to understand two values of the mathematical expectation. A positive result guarantees that your trading tactics at the chosen stage will be profitable. Conversely, the negative or zero MO will produce an opposite result. That is why beginners should avoid risks and choose only positive values. An accurate determination of both potential profits and losses can help traders avoid failures. To do so, they should carefully analyze their own trades or any other real story.
Deposit split. This is the most easy-to-understand money management method. The essence of this approach is that a trader must not deposit all the funds in the brokerage account under any circumstances. Importantly, no trading platform guarantees the force majeure protection. There are always risks of account reset. That is why a trader should have the so-called strategic spare money. These will be the trader’s rainy day funds in case risks are realized. Hedging. This approach employs opening opposite trades in any asset or financial instrument in different but economically related markets. Simply put, traders can open positions in one market to offset risks of a reverse transaction in another market. Hedging is often called the trader’s insurance. This approach is used in money management to minimize losses given the circumstances. Thus, in case of pessimistic forecasts, a market player can not only recover losses in one trade, but also yield profits in another one.
Margin reduction. In order to understand the essence of this approach, the knowledge of the margin in trading is required. Supposedly, you have some funds in your account. When you open a trade, these funds are reserved by a broker in order to compensate for possible losses. This is what the margin is. All you should know is its limit. In traditional money management, the margin should not exceed 15-20% of the total capital. In this case, risks will be minimal even during sharp price fluctuations.
Stop Loss. The order that limits losses is oftentimes undeservingly ignored. Beginner traders can simply not know about all the benefits of a Stop Loss and therefore can unknowingly put their deposit at risk. As for experienced traders, they sometimes intentionally move the order under the influence of strong feelings and hoping for a successful outcome. It seems to them that the expansion of losses will eventually stop and the price will go in the right direction. However, such blind confidence usually ends in a loss of funds.
Under the market rule, a Stop Loss is a must do. There are two simple reasons why. Firstly, Stop orders help traders avoid unnecessary emotional involvement. Secondly, a Stop Loss allows market players to manage their trading risks if the price moves in the direction contrary to expectations. Thus, there is always a chance to close a losing trade with a Stop Loss set in advance.
Diversification. Financial experts call this approach "Don't put your eggs in one basket". Following this rule, traders should not invest all their money in one asset. The biggest part of the capital should be either spent on a variety of financial instruments or saved. A good example of diversification is the use of gold along with other assets. When one of the leading world currencies tumbles, the precious metal increases in value.
Notably, this approach does not suit speculators trading intraday, unlike investors who have enough time to analyze the state of the market to assess emitters and their asset prices. An investment portfolio should be diversified so that losses on one asset are offset by profits on another one. According to experts, a stable portfolio should be diversified equally in the following way: it should contain 1/3 shares of state-owned companies and large corporations, the same amount of shares of fastest-growing firms, as well as average-risk companies.
Risk limiting. Experienced market players advise traders that they use this approach when developing a trading strategy, that is, when they take their first steps in trading. At the initial stage, it is very important to determine the level of losses you can actually sustain on a trade. This level is set as a percentage of the deposit amount. It may vary depending on the amount of funds in the account and the trading strategy used. For example, an experienced trader has a substantial capital and follows a conservative strategy. In this case, the risk limit is 10-15%. Meanwhile, if it is a beginner trader with a $100-200 deposit, the risk limit per trade will be 2-5%.
Summing up, we would like to focus on the fact that traders othen use several money management approaches. Numerous examples show how a combination of well-chosen methods can turn a losing trading strategy into a profitable one. You should always keep in mind that the most important thing is the relevance of the approach. Effective and competent account management always depends on the right choice of a trading instrument.
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