It is always amazing to me that the beginner pays more attention to determining the best entry conditions than to simple money management.  Without money management the beginner has no chance of making it through to becoming experienced, or profitable. Perhaps it’s because money management seems boring, the sort of thing that only a mathematician could love, dealing as it does with percentages and numbers. It’s much more exciting to look at a chart, particularly as the price of your chosen stock shoots skywards – well, I think it’s exciting.

The fact is that without an organized scheme for money management you would have to be exceptionally lucky to be able to continue trading on a consistent basis. In her book “A Beginner’s Guide To Day Trading Online”, Tony Turner warns against trading with “scared money”, that is money that you cannot afford to lose. Such trading is foolish, as you may be unable to separate your emotion from objective assessment of what and how you should trade, and you finish up making bad decisions. But even assuming the money you set aside for trading is disposable, you need to take every step you can to make sure it is not disposed of!

Consider – even the best of traders may only pick the right trades 70% to 80% of the time. The key to making a profit is in selecting trades that have a good reward to risk ratio, that is, if the trade goes the right way you stand to gain several times what you would lose if it went wrong. In fact, in an experiment cited by the Australian trader David Jenyns, stocks were selected at random, and whether to go long or short was also picked at random, and the trades were made. With good money management, even in this scenario a slight profit was achieved, purely because the losing trades were exited quickly while the winners were allowed to run.  Now I’m not advocating that you trade at random!  Obviously, stock selection makes a difference to the potential profit. However, this experiment did show the importance of money management to a profitable business.

An intrinsic part of money management is called position sizing, or asset allocation. This is the process by which you determine just how many shares you should buy. An often quoted guideline is that you should not risk more than 2% of your trading equity on any one position. This does not mean that you only invest 2% in any one company - far from it - but your exit strategy for a losing trade should limit your potential loss to 2%.  In the course of your trading over a period, you will find that you may have five misses in a row, and if you were risking, say, 10% per trade, you would find it nearly impossible to recover from the resulting halving of your account.

While you may think that this sounds obvious, it is surprising how often traders, particularly beginners, trade in the exactly opposite way. After all, when you have done your research and found a trade that you believe will go up, it is natural to want to hang onto it and not sell quickly, even if it starts off in the wrong direction – remember, all big losses started as small losses. Similarly, if the trade goes in the right direction there is sometimes a compulsion to close it out, and feel the satisfaction of making a gain, rather than continuing to ride it up for the maximum profit.

A disciplined approach to money management can make up for a less than excellent trading plan, but, given the vagaries of the market, even an excellent trading plan cannot overcome sloppy money management.