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What is money management?

In stock trading, money management is how you manage your trades to protect your capital. It is also called risk management.

We know that psychology plays a critical role in trading. Instead of a failing strategy, the top reason that investors lose money in trading is that they let emotions like greed, fear, and panic control their trades. Having a money management strategy in place can help to eliminate the impacts of emotions and facilitates rational decision-making.

Basically, your money management strategy, at a minimum, answers the following questions:

• How many shares should you buy?
• How much should you risk on the trade?
• How much profit is sufficient?

To address these questions, we want to share some money management rules that you may find helpful.

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The 2% rule

A simple and effective way to protect your capital is by establishing a strict loss parameter and abiding by it. One popular method is the 2% rule, which means you should never risk 2% of your capital on one trade.

There are two aspects of consideration for this rule. The first is to spread risks—you never know where the price is heading. The second consideration is that even if you put all your money in one trade, it would take dozens of consecutive losing trades before your capital runs out.

This rule could help to determine the number of shares you buy.

For example, assume you have $1,000 in your account and want to buy a stock at $60. With the 2% rule, you should only risk $20. If you want to allow a $5 loss per share, set your stop price at $55. Since you are only risking at most $20, you would only be buying 4 shares (4 shares x $5 stop loss=20).

Note that 2% is not a fixed number. You can set your own loss parameter according to your investment style and risk tolerance. However, once you’ve set a loss parameter, try to adhere to it.

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Stop losses

Trading without protection is dangerous. You may suffer significant losses beyond your expectations. More importantly, unexpected losses are likely to damage your trading confidence. If you set stop orders for every trade you make, you’ll gain some control over your trades and might not panic as easily if the market turns against you.

You can set a stop price based on your trading strategy and risk tolerance.

Looking at the example below, an investor thought the price would break out to the upside and bought 10 shares at $90. Unfortunately, the market proved them wrong and went to the downside. Instead of sitting and waiting for the market to rebound, they placed a stop order at $83. Their long position was closed before the stock tumbled further.

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Lock in profits

You also need to decide how much profit is enough. If you keep waiting for the price to go higher and higher, a potentially winning trade may turn into a losing trade.

You can determine your expected profits by setting a risk/reward ratio. Suppose you set the ratio to 1:2. If you’re risking 5% in a trade, your profit target should be 10%. You can set a limit order to sell the shares with a 10% profit.

A more flexible way to lock in profits is to set a trailing stop order. If you set a 5% sell trailing stop order, the order will only be triggered when the market goes against you. Every time the market moves in your favor, the stop price moves up, helping to lock in profits.

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The bottom line

Building a money management strategy helps to protect your capital and prevent you from emotional trading. Once you’ve built your money management strategy, stick to it and see if it works!