Every trader is looking for a strategy to maximize profits, minimize losses and grow their trading account. Trading can be both rewarding at the best of times and fraught with the risks when things do not go as per plan.
Having a strong, clear strategy and using the right one at the right time can be crucial. A tried and tested approach is the concept of money management which can be the game-changer in helping you get to your trading goals.
So, as a trader whose goal is to grow his account while ensuring risks are kept to a minimum, you will need to have the right strategy to balance out growth with prudent decision making. This is where the techniques of money management come in handy.
No trader can become successful without incurring losses once in a while. It is a part and parcel of trading, whether it is the stock market, the forex market, the cryptocurrency market or any other. The trick here is to be able to limit your losses and find the appropriate money managing strategies to suit a situation.
Why Is Money Management Important?
Like any other business venture, money management is particularly helpful in managing the size of trades done. It is a good tool to ascertain the lot size that you should enter a trade with. With money management as part of his trading armoury, a trader is able to manage the size of his trades as part of the overall trading account.
The focus of money management is to ensure that the growth is steady and the risk of losses kept to a minimum. This may not be a guarantee of sure fire success and high profits but is an assurance against mounting losses in a difficult market.
The size of his trades should be based on the equity in your account. At the same time you need to keep an eye on the volatility of the stock and how much money needs to be put at risk on any one position.
There are many popular methods of money management but choosing the most effective one can be daunting. We will take a look at two popular money management systems – Fixed Fractional and Fixed Lot Money Management.
What Is the Fixed Fractional Model?
Fixed fractional or fixed risk is a money management strategy where the risk is restricted to a fixed percentage of the account. Only a fixed part or percentage of the account capital gets exposed to risk.
The main consideration here is the risk associated with a trade and the volume or the number of units being traded is in relation to that. So, the equity going up or down is proportional to the risked fixed fraction.
Pros Of the Fixed Fractional Model
The fixed fractional technique is particularly suitable for those who prefer withdrawing profits at regular intervals. This also hedges against any losses incurred in the future as the periodic withdrawal of profits protects it from getting reinvested and risking its loss. Here, once the returns are withdrawn, the capital can also be restarted from the same levels.
Given that there is a proportion between the trade amount and the account capital, the risk quotient is negligible. The objective of the fixed fractional model is, therefore, aimed at safeguarding the initial capital as much and as long as possible.
The ability of this model to capitalise earnings is borne by the compounding effect. When there is a streak of successful trades, the position size begins to increase. But in case of a string of losses, the size of the trades reduces. This, in turn, helps minimise the overall impact of the account position.
With the minimising of risks, the equity curve does not see major changes. The appreciation of the account capital is more linear as the equity that is risked is minimal and does not cause huge damage to the account position.
The consistency in the trading results is more predictable as the strategy adopted ensures the volume committed to is stable.
Cons Of the Fixed Fractional Model
Of course, this model does not lend itself well when working with a modest capital. There just is not enough size to make an impactful trade and returns.
The model can get disturbed in case there is a sudden and unexpected loss of a large proportion. With the low risk percentage that hampers trading, it does not leave much room for making a bigger move with smaller lot sizes.
Also, smaller lot sizes mean lesser scope for breakout growth and lower chances of aiming for bigger returns. For a trader looking to grow faster, this money management model and a small capital will take much longer to get to his goal.
What Is Fixed Lot Money Management?
Fixed Lot or fixed ratio is a money management technique that helps compound returns with an increase in the lot size when the account sees growth. This is one of the most basic and widely practised models where a trader sets the lot numbers to trade per position.
Regardless of how the trading performance looks, a trader continues to work on a fixed number of lots per position.
Pros Of the Fixed Lot Money Management Model
Due to the consistency in the lot size used, the fixed lot model is fairly straightforward and even novice traders can grasp it easily. It is also relatively easy to manage unlike some of the more complex alternatives.
In the fixed lot model, the risk is considerably lesser and it helps protect a trader’s capital more than any other. This is because the trade amount is proportional to the capital, thereby keeping exposure levels much lower.
Given the close relation in proportion, it helps maintain a constant growth in returns over a period.
Cons Of the Fixed Lot Money Management Model
The fixed lot model, however, may not be suitable for traders who are looking for speedy and consistent growth. The periodic withdrawals from the account reduce the potential to use the additional capital to have a healthy capital and build on incremental profits.
With this model, the larger an account becomes, the increase in the growth of the position size can become unwieldy and open to higher risks.
This also does not suit large accounts where it could become difficult to manage multiple lots.
The fixed nature of the capital and the amount apportioned for trading leads to situations where the growth in returns can be limited in difficult markets.
Money management is one of the most important strategy elements of a trading plan that traders use in order to improve their performance and ensure safety for the capital. Applying the right strategy will make the difference; you should also implement an approach that best fits your style of trading.
The fundamental idea is to consider the commitment size of your capital and never place all of your money in a single trade or there could be a risk of losing everything. At the same time, the right money management system will preserve the initial trading capital and will help you limit the losses of any single position.