Money management

From Traderpedia

Definition:
Identifying and limiting risk to trading capital.


The term money management can be applied in two ways. One is what can be referred to as portfolio management or investment management. The other can be thought of as risk management, which is how most traders use the term.

Contents

[edit] Definition

Money management, from the trader's perspective, is the process by which one seeks to first identify, then limit the risks associated with holding positions in the market. This can be thought of in terms of pips or points or in actual monetary terms.

[edit] Defining Risk

Traders generally view risk as the potential for the loss of capital. It is a combination of the probability of losing and the potential size of a loss taken. The former is often considered a function of one's trading system/method, and not generally the focus of money management. It is controlling the size of a loss, should it occur which is where traders most often focus their money management sites.

How this is measured varies greatly. The trader managing one position at a time can focus on per trade statistics from her/his trading system, extraneous events such as economic data releases, and the action of correlated markets. Traders holding broader portfolios have more complex risk assessments needs and often use some sort of Value-at-Risk (VAR) measure.

Monte Carlo simulation is a method of evaluating probabilities which employs a random simulation. It can be quite useful in portraying the array of possible outcomes, but can be very intensive in terms of calculation.

Modern Portfolio Theory is a way of thinking about the risk/reward equation, but most traders do not consciously make use of it.

[edit] Methods for Limiting Risk

There are a couple ways traders can limit their risk.

[edit] Stop loss

The most commonly used approach at defining and limiting one's risk on a given trade is the use of a stop order. These orders are used to exit trades at specific points to prevent oversized losses. The problem, however, is that stops are not guarantees. One cannot assume that a stop order will be filled at exactly the price intended. Things such as limit moves, fast markets and gaps may cause your stop order to be filled at an undesireable price.

[edit] Hedging

A hedge allows one to offset, partially or completely, one or more specific risks associated with holding a position or set of positions. This often involves the use of derivatives such as futures and options. Individual traders do not tend to be hedgers, but institutions frequently are.

[edit] Position size

Position sizing is an important factor in risk limitation. It is a simple fact that larger positions put more money at risk than do smaller ones. By using a proper position size, a trader can fairly well define how much of her/his account or portfolio is being risked.

[edit] T2W links