The often somewhat neglected topic of risk and money management turns out to be one of the most important building blocks of stock market trading.
It addresses essential questions such as: When should I limit my losses? How much capital should be allocated to individual positions? When should the amount of capital invested be increased or decreased?
These and similar questions are not only crucial for “survival” in the financial markets, but – when applied successfully – also enable optimal wealth accumulation.
Risk management
Risk management is essentially concerned with keeping losses as low as possible. Various methods of limiting losses through stops are widely used. These range from classic techniques based on points or monetary amounts – such as chart-based stops or fixed stops – to percentage-based stops, trailing stops and volatility-based stops.
An example of a trailing stop:
An investor buys a stock at 100 euros and wants to limitrisk to 10%. If the stock falls to 90 euros, the position is sold. If, on the other hand, the stock rises, the stop is continuously recalculated. A rise to 105 thus results in a new stop level of 94.50. If the stock falls to this level, it must be sold.
One advantage of using stops is locking in price gains. Letting profits run also enables high returns without simultaneously putting those gains back at risk.
Money management
Optimal money management should, on the one hand, ensure the best possible growth of assets and, on the other hand, reduce risk as quickly as possible during losing streaks. It therefore addresses the question of how much capital can be allocated to a new position. The two most common techniques are Martingale and Anti-Martingale money management.
Martingale and anti-martingale money management
With Martingale money management, the invested capital is doubled after losses. We are familiar with this method from casinos, where, in roulette, the bet is doubled in the next round after a losing spin. However, even here, the table limit is eventually reached, so this technique can become dangerous. In the financial markets, especially when using leveraged products, this is a guaranteed path to total loss in the long run.
In professional stock trading, particularly with leveraged products, anti-martingale money management strategies are the most established form of money management. With this approach, the stake is increased only after profits are realized. At the same time, however, these strategies also take into account an important aspect of risk management, as they reduce position sizes following losing streaks.
Fixed capital money management
With fixed capital money management, another financial instrument is always traded once a specific, fixed profit amount is reached. In a concrete numerical example, this means: With an account balance of 30,000 euros and a fixed investment amount of 10,000 euros per product, you could trade three units. Once your account balance reaches 40,000 euros, you could trade four units. In the long term, this strategy would lead to exponential wealth accumulation. At the same time, the principles of proper risk management would be observed. If losing trades occur, the position sizes are consistently reduced again.
The cost averaging effect
A method that conceptually lies somewhere in between is the cost averaging effect. With this approach, a constant amount of money is invested at regular intervals. The cost averaging effect is particularly popular with fund savings plans, as it is relatively easy to implement and the issue of market timing is irrelevant. In this approach, the same amount of money is always invested. Thus, when prices fall, a larger number of shares can be purchased, which leads to a lower average purchase price over the long term. For this effect to pay off for the investor in the form of a return, the price of the security must rise again later.
Conclusion
Even though some aspects of risk and money management may seem a bit dry at first glance, their correct application in practice is of enormous importance. When applied correctly, they help reduce risk when the trading strategy fails, and they contribute to optimal wealth accumulation when the strategy succeeds. In any case, a disciplined approach on the part of the investor is essential.
Author
DI Nikolaos Nicoltsios
Trader and developer of trading systems