Proper Money Management: A Key Part Of A Day Trading Plan
There are two key components of any trading plan; money management and risk control. The two are significantly different, but both are equally important in the protection of a trading account balance. Money management is, simply put, the amount of money a trader is willing to place on each trade. Risk control can be achieved by utilizing the settings which accompany any good trading platform and can help prevent a trader from the risk of overtrading by restricting such things as the maximum loss on a position or the total number of shares.
Over the years the markets have seen plenty of excellent traders exit the business because of one or two trades which took them out of the game. You’ve probably seen or heard it before; the wildly successful trader who’s bragged about their five or six figure trades every day, only to tell everyone they’re taking a “break” from trading due to the huge loss they took on one stock. How does this happen?
Scenarios such as the above happen every day in the trading world without proper, or any, money management techniques. Day trading, unlike long-term investing, can allow a trader to take on a risk threshold in excess of what may be prudent for each trade. This is true because a day trader does not hold any positions overnight. Is it wise to use your entire available margin for one position? Certainly the answer is no. However, time after time, traders not only trade with 100% of the cash in their portfolio, but use typical margin leverage of 4 to 1 to achieve 400% of their available funds in a single position. The simple math proves it would take just a 25% move against a fully leveraged position to wipe out the entire account. Each trader should carefully consider their own risk tolerance, but a general guideline for an “aggressive” day trader is to use no more than 20-25% the account value on a single position. For example, using that formula, an account with $50,000 should maintain a maximum position of $10,000-$12,500. This is a far cry from the $200,000 which is made available on a marginable stock in a day trading account. If a trader uses the platform settings to help manage risk even a complete loss on a trade would still leave 75-80% of the account balance.
Money management is one of the most overlooked aspects in trading despite its relatively simple concept. In the long run, it could be the difference between having a successful trading career or losing it all. If you think that money management just isn’t for you, take a look at the number of stocks that have run over 100% in the past weeks. Using a fully margined account and being on the wrong side of a trade, only a small move is required to almost instantly end what otherwise might have been a promising trading career.