RISK & MONEY MANAGEMENT
Risk & Money management are the key element for the survival and eventually to be profitable in the financial markets. Unfortunately most of the people who approach the trading environment don'survive enough to understand its importance because they have already done serious and sometime irreparable damages to their monetary and emotional capital.
Those who are able to survive and understand its importance and to explore its potential, this represent the entrance to the world of professional trading.
Often the two terms Risk Management and Money Management are improperly used as synonyms when inead we believe they are two different things that should be defined in this way:
Risk Management is the% of the trading capital that we put at risk on each trade or in a given period of time eg. the whole day or the whole month or the entire year etc.
It represents a fixed percentage, rigid (with the appropriate reasonable adjustments) to be considered as the extreme parachute, the limit that protect us from the worst situations (when everything goes wrong).
The purpose of risk management is only to increase our chances of survival; given that a well defined methodology has an edge and is theoretically profitable, the defined Risk Management percentages have the sole purpose of minimizing the risk of ruin; given a methodology with its characteristics (%win/loss and a money management strategy - see below) we know that the sequence of wins and losses are random, then the percentages of Risk Management have to be designed in such a way that an exceptional wide losing streak could not deplete the capital before we can "enjoy" the succession of gains.
When some kind of discretion is involved in our trading, the % of risk management are also very important to stop us before a series of negative events could affect our judgment capabilities making us prone to make poor trade decisions and definitely abandon or trading plan; trading outside our plan will produce trades without any statistical value for a subsequent analysis.
Risk Management percentages do not have however any effect on the intrinsic profitability of a methodology, it is not an edge by itself (beyond the psyco effect and the survival seen above) it does not have any direct influence on the trading edge.
Money Management is the management of the position/positions in every single trade.
Making a Money Management plan means do define how many lots to enter with, where to put the stop loss, where the take profit, how to enter (all inn or scale in) and how to get out (all out or scale out), how to make, if any a trailing stop and finally how to eventually add to a winning position.
The combinations of entry and exit strategies are:
1) ALL IN - ALL OUT: single entry with all contracts together with an unique exit with all contracts together (in this case there is almost no MM)
2) SCALE IN - SCALE OUT: you enter progressively in an area up to the n.° max of contracts you want to trade and exit progressively on another area at various profit targets
3) SCALE IN - ALL OUT: you enter progressively in an area up to the n.° max of contracts you want to trade and exit all together at a specified unique target.
4) ALL IN - SCALE OUT: a single entry with all contracts together and progressive exit within a defined area at various profit targets
There is a wide range of possibilities to design a Money Management strategy, each combination of rules has particular advantages / disadvantages and should therefore be chosen depending on the time frame, the methodology, the particular instrument traded, the market conditions, the psychological personal strenghts and weakness, preferences etc.
It should therefore be tested, applied, improved, reapplied, adjusted for changed market conditions, for different entry techniques, different instruments, and so on, it is a process of continuous improvement, adaptation and optimization.
It's critical to learn to deeply analyze all of our trades to extract the information useful to improve and optimize our money management strategy; this is a subject on which we will do many in depth investigations.