Money management and stop-losses

It can be very confusing for a novice trader to unscramble how money and risk management tie in with the practicalities of deciding whether or not to open a trade, and where to place stop losses.

 
 

 

How to manage your money

It can be very confusing for a novice trader to unscramble how money and risk management tie in with the practicalities of deciding whether or not to open a trade, and where to place stop losses.

There’s a lot in that sentence and it needs to be broken down to be properly understood and appreciated. That’s not because I’m offering up some special and unique insight - far from it. Experienced traders with a successful track record know all about this conundrum and how best to juggle the parts within it. But it’s important to appreciate that there will be plenty of occasions when, no matter how tempting it may be to open a position, you should resist at all costs if the risks are too great given your money and risk management parameters.

The basics of money and risk management are covered under “Trading Psychology” in our Trading Guides section. What this blog will consider is how to marry up money management with the reality of deciding whether to open a trade or not. Remember: we’re dealing with leveraged trading here. That means dealing on margin where potential profits are magnified, as are potential losses.

Let’s take a simple example of a spread bet on the UK100. The Notional Trading Requirement (NTR) is 25. This means that you need a minimum of 25 times your bet size in your account in order to open a bet. So you would need a clear £25 for a £1 per point bet. Now, this money must be unencumbered, meaning that it is not being held as either initial margin or variation margin for any existing position. It is also the absolute minimum that you must have in the account to open the position. In other words, if you had £25 in your account then you would be able to open a £1 bet. However, if the UK100 moved against you, even by just a few points, you would need to top up your account to keep the position open. Consequently, it’s always sensible to hold more funds in your account than just those required to cover the NTRs of your open position(s).

Now, while the NTR has a direct bearing on what you can and can’t trade when considering your account balance, it is quite different from money and risk management. So let’s say that you have done your money management and divided up your risk capital so that you are prepared to risk £100 per trade. Now let’s assume that you’ve been watching the UK100 and waiting for a particular trade set-up. Let us say that you’re expecting the index to push higher but are waiting for the right moment to pull the trigger. We can see an example of such a set-up in this chart section below:

https://www.spreadco.com/assets/23.01.17pm.png

Looking at the left hand side of the chart we can see that the UK100 dipped below the upper horizontal which comes in around 6,750. It then found some support around 6,680 (which is marked by the lower horizontal) before breaking back above 6,750. We then see a number of candles which indicate some indecisiveness in the market. Nevertheless, the UK100 seems to be holding above 6,750 which is a good enough signal (in this example) for us to buy the index. Now we have to decide how much we should (or can) buy given our maximum £100 risk-per-trade and where we should reasonably place our stop-loss. First of all, we know there’s some support around the 6,680 level, so this should be the basis for our stop. Generally, it’s a good idea to avoid round numbers for stops so we may leave it a bit below here, say at 6,674 to give ourselves a little bit of extra leeway should there be a number of market stops around 6,680 which could exacerbate selling pressure. Now let’s assume that we can buy the UK100 at 6,756 - a bit above support around 6,750. If so, that means we are risking 82 points (6,756 - 6,674 = 82) assuming that there’s no gapping through our stop loss.

So, we could make a £1 per point bet as this would fall under our £100 per trade risk threshold (£1 x 82 points). But a £2 per point bet would mean taking on too much risk, even with a stop 82 points away from our opening level. If the distance between our opening level and our stop loss is above £100, then, given our money management rules, we shouldn’t be doing the trade.

It may be that sticking to these rules means you pass up on trades which could have subsequently proved profitable. Yet all traders miss out on good trades from time to time. While this can be very frustrating it is better than running down your risk capital because you have bent or broken your own rules. And by preserving your risk capital you’ll also be conserving your mental capital as well. This will help you maintain a healthy attitude to trading. Ultimately it’s worth exercising patience, being disciplined and understanding that deciding not to trade is still a trading decision. 

 
 
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