Money management in day trading
You will learn about the following concepts
- What is money management
- Why you need it
- Expected return
- Probability of ruin
In the chapter ‘Money Management‘ of Trading Pedia’s Forex Trading Academy, we discussed some of the key points of risk management when trading currencies, and most of those principles also apply to day trading, even if you are operating in a different market. In this chapter we will introduce a few more terms and expand our knowledge of money management.
Money management, as you can guess by its name, is all about managing the size of your positions, determining the size of your initial capital, estimating whether and how much to withdraw after a good series of wins in order to keep your account balance from growing beyond a point where you can easily control it, etc. The core basis of money management is to help you maximise the return on your capital while protecting it.
Probably the most important task a novice trader faces when beginning to trade is not to lose their starting capital in the first year. We know that becoming an accomplished trader requires years of experience, which is earned only through practice. Therefore, it is of utmost importance for a trader to use a proper money management strategy in order to survive and ‘live to trade another day’.
- Trade Forex
- Trade Crypto
- Trade Stocks
- Regulation: NFA
- Leverage: Day Margin
- Min Deposit: $100
Balance
In order to do that, each day trader must find a balance between their risk profile and return expectations, and the amount of risk they are exposed to with each trade. For example, if you are a highly risk-prone person, you might want to risk 20% of your total capital with each trade, but, as you can guess, that is not a good idea. Some trading gurus risk up to 6-8% of their capital per trade, which is still immensely high, but the fact that they have 10-15+ years of experience and large amounts of backup capital generally ensures their long-term success.
Another drawback of committing too much money to a single trade worth considering is the so-called opportunity cost. These costs stem from the fact that when you lock your money in one trade, you won’t have funds to enter any other trade, thus missing out on that alternative profit. Thus, each dollar you trade carries certain opportunity costs. Good traders know that and seek to minimise them by committing smaller amounts of money to single trades, thus always having free capital to capitalise on a reliable trade signal.
Although high risk exposure may be devastating, the opposite extreme is not a good option either. If a trader enters positions with too little money, their performance will suffer and the results may be discouraging as they miss out on good opportunities. This is why you will see in most trading guides, including here, people advising you to risk between 1% and 2% of your trading capital per trade. Of course, if you are unsure at the start, you will enter smaller positions, but eventually you will reach that amount. It is crucial to remember that traders should always place themselves in their comfort zone; therefore, you need to risk only as much as you think you can handle emotionally. Being unable to digest the higher risk exposure in a certain situation will lead to emotional distress and may result in a hasty decision you might regret later.
Chance of bankruptcy and profit outlook
The worst thing that can happen to a novice trader – in fact to any trader, although the more experienced may take it more easily – is to see their account wiped out. The chance of that happening can be calculated using a simple formula that measures the so-called probability of ruin. However, first we will need to extract some statistical data from the trader’s performance on which to base it. Using the same data we can calculate another key figure – the expected return.
Expected return is a figure based on four values derived from your trading history, which shows how much money you can expect to make if you continue to trade using the same strategy and money management system. These four values are the following:
– the percentage of winning trades
– the gain on winning trades
– the percentage of losing trades
– the loss on losing trades
We can then use these four values to calculate the expected return as follows: % of winning trades × gain on winning trades – % of losing trades × loss on losing trades = expected return.
Let’s say a trader has 55% winning trades, each of which earned them 1.2%, and 45% losing trades, each incurring a 1% loss. Their expected return would then be: 0.55 × 0.012 – 0.45 × 0.010 = 0.0021, or an average gain of 0.21% per trade. Of course, all those calculations need to be based on a database rich enough so that the numbers are smoothed out. This means that, in the long term, if you keep trading the same way you have up to now, you will earn 0.21% per trade.
The second calculation of significance is the probability of ruin. As we said, it measures the chance of a trader wiping their account and, logically enough, it is also based on their performance. Here is how the formula looks:
[(1-A)/(1+A)]^C = R, where
– A is the advantage on each trade, i.e. the percentage difference between winning and losing trades. In our case, it will be 10% or 0.1 (55% – 45%).
– C is the number of trades in an account. Let’s assume that we are dividing our account into 20 equal parts today, as we are planning to enter 20 trades. Our probability of ruin calculation will therefore look as follows:
[(1-0.1)/(1+0.1)]^20 = [0.9/1.1]^20 = 0.018071595, or you stand a 1.8% chance of wiping your account with those 20 trades today.
Do not ignore it
Although at first glance bankruptcy appears to have a relatively small chance of occurring, the risk is nevertheless present and you might be unlucky enough to experience it. However, as is evident from the calculation, by increasing the advantage (raising the number of winning trades as opposed to losing ones) you will be exposed to less risk of ruin. Moreover, if you do the maths yourself, you will see that the smaller the number of trades, the greater the probability of ruin is, and vice versa. Thus, risking less and entering a larger number of trades will help you trade for longer.
Another detail you should consider is that this calculation is based on the assumption that the losing trades bring your account to zero, whereas you can protect yourself from incurring heavy losses by using protective stops. However, stop-loss orders won’t help you against consistent account erosion, which is something you need to address by honing your trading skills and attaining better entry judgement.