Research has shown that to be a successful trader, he/she has to also be a strictly disciplined trader. In the stock market, money management is an important part of the trading discipline. A precise money management will keep an investor in a profitable position from a mathematical view point.
In this article, we will learn about the money management and its importance.
Generally speaking, there are three possibilities for movements in stock price i.e. either the price will increase, decrease or remain constant. Now, when the price remains stagnant, investors will not be affected much. Also, practically speaking, stock price will not remain stagnant for a long period of time. Thus, excluding this possibility, we can say that the price of the stock will either increase or decrease.
Mathematically speaking, possibilities of making a profit in any single trade is 50%. Now, considering this number, we can say that traders should be at "no loss no gain" position after a series of trade which means none of the investors should lose in the stock market.
However the reality is woeful, more than 90% of the retail traders lose money in the market.
In every secondary trade, one trader will lose and others will gain but sadly, considering the above fact, no matter who wins or loses in the sole trade, at last, it’s the 10% trader who makes a profit. Loss of 90% traders is the profit for the 10% traders.
There is a huge opportunity in the market if we trade with the proper money management and constantly upgrade our knowledge accordingly, then we can fall in the 10% category and can accumulate huge wealth from the stock market. Either we will be rich or help to make someone rich in the stock market.
Sign of Poor Money Management
Not trading with proper stop-loss: It is an important sign of poor money management. If we are trading without a proper stop loss, then we can lose all our profit in a single wrong trade. Trading with stop-loss manages our risk and protects our capital.
Not trading with proper profit target: If the stock price increases and if we are trading without the profit target, then we would not know when to exit the trade with the gain. The increasing stock price gives rise to the rumors and those rumors will influence the investor and they start expecting a very high price. Investors will wait for that highest price and stock will start devaluating. As a result, investors will hold that losing trade until it reaches the rumored set price which may take years to achieve. However, if we trade with a realistic profit target, then we can exit with the profit and can look for other opportunities in the market.
Investing all available amount at once and investing only in the single stock: Investor buys a stock in the expectation that the stock price will increase but expectation rarely meets the reality. After the purchase of stock, either stock price will move up or down and if the stock price decreases then for reducing the average buying cost, we should have a backup capital. We have to prepare for the bad times because good never make us feel anxious. Return from the single stock is very uncertain so if we invest all our capital in the single stock then we are taking a huge risk.
Not maintaining sound risk to reward ratio: In the Stock market, either my trade be a loser or a gainer. If my trade goes as I thought then I will make a profit (reward) and if it goes wrong, then I will make a loss (risk). My reward has to be greater than the risk in every trade that means if the trade goes in my favor then I should make more money than I lose in case if it goes against me.
The magic of Risk to Reward ratio:
1st trade (loser)
2nd trade (loser)
3rd trade (gainer)
5th trade( winner)
6th trade (winner)
In above case, I assumed that if a trade goes in my favor then I will make Rs 10,000 and if it goes against me then I will lose Rs 5000 that means I have traded with the "reward/risk" ratio of 2. In simple word "Reward/Risk" ratio of 2 means, I will lose Rs 1 if the trade goes wrong and I will make Rs 2 if it goes right. Further, I assumed that out of six trades only three trades were gainer that means my trading strategy has an accuracy of only 50% but still I managed to gain a decent profit of Rs 15,000. A sound reward to risk ratio can grow wealth in the stock market even with 50% accuracy.
How can we survive an uncertainty of the stock market with the money management?
To understand this first consider this example, if we toss a coin then mathematically there is 50% probability of getting heads but if we toss a coin for 10 times then practically speaking the possibility of appearing heads and tail one after another in series is almost zero. The result will be random, we could get 5 heads in a row or 5 tails in a row but if we increase the number of event to 400-500 then the ratio of heads and tails will be somewhere near 50%.
Let us assumed our trading strategy has 50% accuracy that means out of 20 trades 10 trades will be a winner and remaining 10 trades will be a loser. The result of a single event is random that means our first 10 trades can be a loser or first 5 trades can be a winner. Thus, we need to take a risk in such a way that even if our first 10 trades goes against us then we could still enter the market with enough mental and financial confidence.
From the Mathematical viewpoint, the probability of 3 loosing/winning trades with the trading strategy accuracy of 50% is 12.5% that means after the 2 losing trade the probability that next trade will be a winner is 87.5% and the probability of profitable trade after 3 losing trades is 93.75%. The probability of winner trade after a series of nine losing trade is 99.90%.
As the number of trade increases the ratio of winner trades will come near to 50% and with the fair reward to risk ratio we can make decent returns from the market.
We can improve our trading strategy accuracy by constantly upgrading our knowledge in the market and remember money management is not a strategy. We cannot take random shares merely on the basis of risk to reward ratio. We need to choose stock on the basis of respective stock market analysis and have to mix money management with it.
Key points to remember for standard money management
Always trade with the stop loss and profit target.
Take a risk in such a way that you could survive the streaks of 10 losing trades.
Don’t invest all your capital in single stock.
Don’t invest all available capital at once.
Never take a risk of more than 5% on the single trade.