Money management in trading

economic-dictionary

Currency management in trading is the branch of stock investment that studies the maximization of profitability and risk control.

Money management is also known as risk management. Along with stock market analysis and trading psychology, money management is one of the three fundamental pillars of investing in the stock market. For a trader to be consistent in the long term, he must master this discipline. Mastering this discipline does not imply having deep and extensive knowledge of the subject. But, rather, elementary knowledge about it. The fundamental principle in trading areas was dictated by George Soros and dictates that:

You could say that this principle is the beginning of principles. What he comes to say is that more important than the percentage of success is the profitability that is generated when it is correct. And, conversely, more important than the failure rate is the amount of each loss. Behavioral finance studies, among other things, why it is so psychologically difficult to earn more when you win than what you lose when you lose.

Success rate vs risk / benefit ratio

To illustrate the importance of the principle of the principles of money management, we will show an example. For this we will put three cases. In the first case (trader A) the percentage of hits is very high. The second case (trader B) is that of a trader whose success rate is 50%. In the third case (trader C) the trader fails most of the time. We will assume that the three traders perform 100 trades each.

  • Trader A

If you perform 100 trades, since the hit percentage is 80%, you will hit 80 trades. In the same way, 20 of the 100 operations will obtain losses. Thus, as every time you hit, you win 10 dollars and every time you miss 40 dollars, we will proceed to calculate your profit in monetary terms.

Profit = (Number of trades that win x profit) - (Number of trades that fail x loss)

Profit = ($ 80 x $ 10) - ($ 20 x $ 40) = 800 - 800 = $ 0 profit.

Trader A hits many times, but whatever he wins he loses the few times he misses. The end result is $ 0. Despite getting a lot right, it fails to generate a positive return.

  • Trader B

If you perform 100 trades, since the hit percentage is 50%, you will hit 50 trades. In the same way, 50 of the 100 operations will obtain losses. Thus, as every time you hit, you win $ 20 and every time you miss you lose 10 dollars, we will proceed to calculate your profit in monetary terms.

Profit = (Number of trades that win x profit) - (Number of trades that fail x loss)

Profit = (50 x 20 dollars) - (50 x 10 dollars) = 1000 - 500 = $ 500 profit.

Trader B is right half the time. The end result is $ 500. Despite being less correct than Trader A, he manages to obtain a more than positive return.

  • Trader C

If you perform 100 trades, since the hit percentage is 30%, you will hit 30 trades. In the same way, 70 of the 100 operations will obtain losses. Thus, as each time you hit, you earn 40 dollars and each time you miss you lose 5 dollars, we will proceed to calculate your profit in monetary terms.

Profit = (Number of trades that win x profit) - (Number of trades that fail x loss)

Profit = ($ 30 x $ 40) - ($ 70 x $ 5) = 1,200 - 350 = $ 850 profit.

Trader C is, without a doubt, the one with the fewest hits. They are correct only 30% of the time. However, it is the one that obtains the most benefit.

The risk / reward ratio

Continuing with the above, we conclude that the fundamental aspect is the risk / benefit ratio. The risk / reward ratio establishes how many dollars we earn for each dollar we lose. In other words, a risk / reward ratio of 1: 2 implies that when we get it right we win two and when we fail we lose one. In other words, we win twice what we lose. On the contrary, a risk / reward ratio of 3: 1 means that when we get it right we win one and when we fail we lose 3. In other words, we lose three times what we win.

The risk-benefit ratio formula is:

Advanced money management techniques

The previous principle, and the correct analysis of the risk / benefit ratio, constitutes the fundamental principle. Without that principle there is no point in using all the other techniques. However, there are much more advanced money management and risk control techniques. They are refined mathematical techniques and, in some cases, highly complex. These techniques make it possible to estimate risk in a more realistic way. An example of some techniques used to control risk and optimize the money management process are:

  • Jensen's Alpha
  • Value at risk (VaR)
  • Conditioned Value at Risk (CVaR)
  • GARCH models
  • Sharpe ratio
  • Antimartingales
  • Kelly's F
  • Monte Carlo simulation
  • Portfolio diversification techniques
  • Hedging techniques
  • Drawdown

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