Learn How to Manage Risk in Trading by Using Simple Money Management Rules

Let’s say you’ve bought a fantastic smartphone for Rs.50,000. 

You’ve gone through all research before buying the phone and made sure that you’re buying the best version in the market.

However, opposite to your expectation, you see that the phone performance is not to your liking. You expected something, but the phone failed to deliver those expectations. 

Every time you interact with the phone, you’re not happy.

After a couple of days, you meet a friend of yours, and he is interested in buying the phone from you for a price of Rs.35,000.

Would you be interested in selling the phone for Rs.35,000 (and through incurring a loss of Rs.15,000 based on your purchase price)?

Or would you avoid the deal and prefer to keep the phone with you even though you dislike it because it’s not meeting your expectations?

This event of holding on to a product/service, even though it’s not giving what we expect it to provide us with, is called “Loss Aversion.”

You don’t want to sell the phone because the pain of losing Rs.15,000 feels worse to you than holding on to the phone and using it daily.

A similar sort of behavior happens to traders when they make trading decisions.

A trader might buy, let’s say, Reliance Industries’ shares at Rs.2000, hoping that it will go up. But against his expectation, the price goes down to 1900 now.

Will he look to sell his Reliance Industries share at Rs.1900 now (and incurring a loss of Rs.100 per share).

Or Will he be looking to hold his share, expecting the price will bounce back and move above Rs.2000 so that he can gain if it moves up?

Most traders cannot book a loss of even Rs.100 per share and prefer to hold instead, hoping that the price goes in their favor in the future. But most of the time, in such situations the price will continue to go down.

1850
1800
1750
And so on.

By the time he sees the price around Rs.1750, he gets shocked and can’t withstand the loss anymore and then decides to exit at Rs.1750, incurring a total loss of Rs.250 per share in this trade.

Let’s flip the same scenario and look at it from a professional trader angle.

He buys the Reliance Industries shares at Rs.2000 and expecting them to go up. At the same time, he also knows when he’ll get out of his position if the price does not move in his favor.

He sets his loss in advance and exits the trade as trade hits the stop loss level of 1950. If he decides that Rs.50 per share is all he can afford to lose in this trade, and If the price goes down to Rs.1950, he will exit his position for a loss of Rs.50 per share.

And he’ll wait for the next trade.

His “Loss Aversion” tendency doesn’t kick in, and he can take the loss of this trade without feeling emotionally bad.

How are professional traders able to take a loss without pain? What exactly goes inside their head when they take the loss? 

It turns out that the secret of successful trading lies not only in a good trading method (precise entry and exit rules). But also in excellent money management rules of trading skills possessed by the trader. 

In this article, we’ll learn.
1) What is Money Management?
2) How to Execute Proper Money Management Rules in Your Trading?
3) How do Money Management Rules in Trading help in Taking a Trading loss like a Pro?

money management rules in trading

#1 What is Money management?

Money management is simply the art of deciding how much money you’re willing to lose on a particular trade. The key to becoming successful in trading can be traced back to sound money management skills.

Let’s say you have got a trading capital of Rs.1,00,000.

You’ve to manage this capital so that you increase your chances of success in trading.

With a capital of 1 lac rupees – please don’t dream of trading 50 lots of Nifty Futures and making tons of money. It’s not going to happen, and it’s a sure-fire way to lose your entire trading capital.

Instead, it would be best to focus on getting good at managing this small amount of money and looking to earn a small profit. That should be your first goal. 

Once you’ve got a grip of your trading method and good money management skills in trading, then you can always trade with a larger amount.

Initially, your goal is not to make a fortune. Instead, your goal is to implement money management rules in your trading system and stick to the rules you’ve created for yourself.

Let’s understand the concept with an example.

With a trading capital of Rs.1,00,000 – we are looking to trade one scrip. Let’s take stock Reliance Industries, for example.

If you buy 50 shares of Reliance Industries at Rs.2000, you need to know in advance how much money you are prepared/willing to lose in this trade if the trade goes against you.

For example, If the price drops to 1980, you’re sitting at a loss of Rs.1000.

If it drops to 1950, you’re sitting at a loss of Rs.2500.

Rule no. 1 is always to arrive at an amount you’re pretty comfortable losing on a per-trade basis.

Remember the famous trading proverb, “Cut your trading losses short and let your profits run.”

The quicker you cut your trading losses short. The more capital is available for you to take the next trade, resulting in a big winner. But how do you decide how much to risk on a per-trade basis and how to implement the same? We’ll find out in the next section.

#2 How to Execute Proper Money Management Rules in Trading?

There is plenty of money management rules in trading out there. However, we’ll discuss the two most commonly used methods and find a way to implement them right away in your trading.

1. Fixed Percentage Method

2. The Drawdown Method

1) Fixed Percentage Method

In the fixed percentage method, we decide how much percentage we will risk on a per-trade basis based on the availability of trading capital. If your Trading capital is Rs.1,00,000 and you wish to trade one stock, let’s say Reliance Industries.

Your money management goes like this.

Based on your trading method, you get an entry signal for a long trade at Rs.2000. And you also know where you’ll be keeping your stop loss in case the trade goes against your favor.

For example, let’s assume the stop loss, in this case, is Rs.1980 So, we’re risking Rs.20 per share to know whether the trade will work in our favor or not.

If you’ve decided to risk 1% percent on a trade-by-trade basis, then Rs.1000 is what you can afford to lose per trade based on your trading capital. (1% risk on a trading capital of Rs.1,00,000).

Based on this risk amount of Rs.1000, you’ve to compute how many shares you can buy – in such a way that if the price goes against your favor, your maximum loss is only Rs.1000.

The formula is – Number of shares to buy = (Risk per trade) divided by (entry price minus stop-loss price).

So in our case, the number of shares to buy = 1000/(2000-1980) =1000/20 =50 shares

If we end up buying 50 shares at Rs.2000 and the price hits our stop loss at Rs.1980, then we’ll be losing Rs.1000 on this trade.

Aren’t we negative by thinking about stop loss before taking the trade?

Well, anything can happen anytime in an uncertain market, it’s best to decide the loss per trade upfront. In this way, you’ll not be worried in case if the stop loss gets hit. And you always know that you’ve got the chance to take one more trade and that might end up as a winner.

2) Drawdown Method

We’re allocating a fixed amount of money for a series of trades put together in this method. For example, we’re deciding to risk 1000 rupees per trade for the next 40 trades.

So in total, we’re risking Rs.40,000 for the entire series of 40 trades. After 40 trades, if we end up in profit, then we continue the process again.

If after 40 trades, if we end up in a loss, we will take a break and assess our trading method and plan again – Refining the entry/exit rules.

In this method, the trading capital is Rs.1,00,000, and the drawdown capital we require to take a series of 40 trades is Rs.40,000 (Risking 1000 rupees per trade).

So, a total of Rs.1,40,000 needs to be available in your trading account to deploy this money management method.

Note: The formula used to know the number of shares to buy is the same as discussed in the Fixed Percentage Method section. 

Now, let’s move on to understand how money management helps us handle trading losses effectively.

#3 How do Money Management Rules in Trading help in Taking a Trading loss like a Pro?

Let’s look at a picture of how a beginner trader’s profit/loss will look like for a series of 6 trades.

Assuming he is trading with a capital of Rs.1,00,000. But he doesn’t use any proper money management techniques. He buys and sells based on his emotions.

Trade 1 = Profit of 1,000
Trade 2 = Profit of 2,000
Trade 3 = Loss of 8,000
Trade 4 = Loss of 4,000
Trade 5 = Profit of 3,000
Trade 6 = Loss of 12,000

Net Loss of Rs.18,000 after a series of 6 trades.

From the sequence of trades, one can see that this trader cut his profits short and let his loss run for longer. Yes, due to the Loss Aversion behavior we discussed earlier, he cannot cut his losses short. As a result, every trade will be a nightmare for him.
 
Because he doesn’t know how much he will lose on a per-trade basis, he hopes and pray for one big trade which will wipe out all his losses. But most of the time, it won’t happen.

Let’s look at a picture of how a professional trader’s profit/loss will look like for a series of 6 trades.

Assuming he is trading with a capital of Rs.1,00,000. And he implements a 1% risk per trade technique in his trading. 

Trade 1 = Loss of 1,000
Trade 2 = Loss of 1,000
Trade 3 = Profit of 3,000
Trade 4 = Loss of 1,000
Trade 5 = Loss of 1,000
Trade 6 = Profit of 4,000

Net Profit of Rs.3,000 after a series of 6 trades.

Suppose one goes through the above sequence of profit/loss. In that case, one can easily see that this professional trader is able to cut his losses short in all of his losing trades. 

Because he knows that as long as he can cut his losses short, he can always take part in the next trading opportunity, which might give him an excellent winning trade. He always looks to profit over a series of trades by not losing individual trade to his heart/mind. 

What’s the one thing you can do today?

Implement proper Money Management in your trading system either based on the Fixed Percentage method or Drawdown method.

And you would have eliminated the loss aversion behavior from your mental environment. That’s the key to take a trading loss like a Pro.

About the author

Divesh Jotwani is a full-time trader in the Indian stock market. He has spent over 20+ years researching and discovering WD Gann's methods and applying them day-in and-out markets.