Money Management and Risk

Written by Miroslav Marinov

Miroslav Marinov

Miroslav Marinov, a financial news editor at TradingPedia, is engaged with observing and reporting on the tendencies in the Foreign Exchange Market, as currently his focus is set on the major currencies of eight developed nations worldwide.

, | Updated: October 30, 2024

When it comes to trading, investors usually tend to pay more attention to the reward side of an investment. However, it is only half of the so called portfolio design. The other half of the investing process is usually associated with money management and the nature of risk.

We can say that money management refers to the risk side of an investment, a whole system of measures that is meant to avoid financial ruin. It is related with measuring and managing the risk of loss and how to utilize your capital in the most efficient way.

In investing there usually exists a trade-off between reward and risk. Neither of these two concepts can be measured with precision, while the amount of risk to reward is a matter of how tolerable you tend to be for risk. It is in human nature to feel happy when being rewarded, but different traders usually have different thoughts about the level of risk they can accept. In investing no reward is guaranteed, but unfortunately, risk is present all the time.

Risk is the amount and probability of a loss or series of losses, which an investor can realize when trading in the global markets. The probability of a loss occurring is as vital as the amount of loss itself.

No trading system is 100% profitable

There has never been a trading system, which never registered a loss on any trade, a system that provided its beneficiary with 100% chance for profit. Such a trading system is an ideal, which has never been achieved, despite the many efforts during past decades, and will probably never be achieved. The pursuit of such a flawless trading strategy can become an obsession, while losses are inevitable.

Risk of ruin

Ruin is another highly possible scenario in trading. Each day traders are forced out of the market, with the major reason being that they did not utilize a measure, aimed at the assessment and control of risk. The area between flawlessness and ruin is a compromise between profits and losses, also known as rewards and risks of a trading strategy. The possibilities between flawlessness and ruin are limitless and, to a great extent, depend on ones personal preference for risk.

What does money management strive to accomplish?

We can say that the trade-off between rewards and risks influences the final success or failure of a particular trading strategy, which leads us to the major goal of money management – to maximize ones return with risk being kept at minimum. The same can be said also as follows – to make regular, successive profits with minimum probability of losing your entire capital. The extremes could range between trading highly leveraged options and futures contracts with an untested system, on one hand, and strictly cash, on the other hand. A cash investment in theory has no risk. A cash position is not associated with the risk of losing your capital. However, some experts state that cash positions are susceptible to the risk of inflation, because during inflationary periods they may lose their purchasing power.

Trading systems should always regard risk

Beginner traders should note that even a good trading system is not secured against losses, if it does not consider risk. Money management can turn such a system into a reliable one, but money management alone cannot do anything to help a system, which does not work.

When designing a strategy, the first move, which every trader should make is finding a workable system, one that consistently demonstrates a larger number of profitable trades than losses. The system may be based on fundamental indicators, on technical indicators, or both. Every successful trader follows a different method or system of entering the market, but all traders implement a money-management system, which to protect them against losses. Most traders will confirm that actually money management is far more important than the trading system itself.

The second step is to determine in which markets the system will trade and which events/indicators it will focus on.

The final step is to combine these systems and events into a strategy, a point at which the concept of money management comes to life.

Another fact also worth noting is that money management theories mostly focus on price and size (that is the reason why money management is also known as ”position sizing”). This means that assessment and control of risk are notions technical in their nature. Traders who use fundamental analysis are usually not able to evaluate risk in the marketplace only with the help of fundamentals. It will be difficult to define the initial capital, the trade size in shares, currency pairs or futures contracts, the execution style. All these issues depend on technical studies and the use of price action.

We can say that the object of money management is to maximize the best situations and avoid or diminish those situations, which could lead to loss of capital.

Next, we shall discuss the various risk concepts.