Money Management and Risk
Oct 17, 2011 at 11:19 am in Risk Management by
You will often see the phrases ‘risk management’ and ‘money management’ used interchangeably, as though they are one-and-the-same thing. But they’re not, as I will explain.
Risk management is all about managing the amount of risk (potential loss) you take when entering a trade, the likelihood of that risk being realised, and the potential reward that you are trading off against.
Money management is all about managing your cash pile and allocating a proportion of it to each trade in order to ensure that you stay in the game long enough for your trading strategy to prove fruitful.
When you place a stop order at 10% below your entry price — and no closer, because the instrument you are trading typically exhibits 10% volatility – that’s risk management.
When you decide to risk no more than 1% of your £10,000 available trading capital on a trade – irrespective of the characteristics of the particular instrument — that’s money management.
Clearly there is a relationship between the two, and the smart trader only takes trades whose risk characteristics also fall within his money management criteria. Here is a concrete example:
The FTSE 100 index has been oscillating within a range between 4500 and 5000. As a swing trader, when the price hits 4600 you intend to open a £1-per-point long trade with a stop order at 4450 (which is safely below the trading range) thereby giving a risk of £150. This risk falls outside of your money management criterion of risking no more than 1% (or £100) of your £10,000 trading capital on any one trade. You decide to walk away from this potential trade.
When the index price falls a little further to 4550, the lower inherent risk of £100 (assuming the same stop level) does fall within your money management criteria, so you take the trade at this price.
Note that waiting for the price to fall a little further was just one way of resolving the trade-off between risk management and money management. Some combination of a tighter stop order, a smaller position size, and less stringent money management criteria (e.g. 2% maximum per trade) would also solve this problem. When making this trade-off, keep in mind that the stop order should not be so tight as to almost guarantee a stop-out, that the trading platform might not allow trade sizes of less than £1-per-point, and that there is really little point in setting a blanket maximum trade size of 1% (of trading capital) if you decide to break this money management rule arbitrarily on a particular trade.
I began this article by asserting that the terms ‘risk management’ and ‘money management’ are often used synonymously. In this context, while I don’t entirely agree with it, you might be interested to know that Van Tharp — who writes extensively on these topics — uses the term position sizing as a synonym for ‘money management’.
Tony Loton is a private trader, and author of the book “Stop Orders” published by Harriman House.