The first point to mastering money management is that you have to understand when youíre trading on the stock market is that you are playing the odds Ė but unlike many forms of gambling, you can make money. The key to making this money is to respect the risk that is part of the market, and manage it. Money management is a set of rules and guidelines that enables you to turn a profit. By being triumphant with your money management skills, you can keep your risk at a level at which youíre comfortable with, keep from making poor trading decisions, and ensure you donít loose your trading capital. This is why it is so important to follow money management rules.
Why do these money management rules work? You know, itís funny. I once thought I had a fool-proof way of making money on roulette. You see, Iíd bet on red and black. Iíd sit at the table. After the ball had landed on black or red five times in a row, I would start betting on the opposite color.
Letís say I had five reds in a row. I would then start to bet on black. If I was wrong, I would go ahead and double down, so that if I started my bet at one dollar, the next time I would be able to bet two dollars, then four dollars, then eight, then 16. With this system, eventually Iíd win and Iíd come out one dollar ahead.
So, here I am at 23 and Iíve set up my computer program to test my theory. I made a ridiculous amount of money in the program. I really thought I had the Holy Grail here. But, if itís so easy for an 23 year old to figure it out, why arenít all the casinos out of business and why arenít weíre all millionaires? Unfortunately, roulette doesnít work this way.
You see, if weíre flipping a coin, heads has a 50 percent chance of turning up on each flip of the coin and so does tails. But, each flip is independent of the last. The last coin toss has nothing to do with the one before it, each flip is a random event. This means itís possible to get a hundred heads in a row if you do it long enough, and believe it or not, thatís what happened to me. When I first played roulette in a casino, I saw a string of 23 blacks in a row. I went home defeated.
Trading is the same. A percentage of your trades will not work out. A certain percentage will not go in your favoured direction, and the next trade has nothing to do with the last one. Even if you have the worldís most accurate method, over time you will go broke if you donít practice good money management.
Money management rules include defining your trading float, setting your maximum loss, calculating your stop loss, and most importantly learning how to choose your position size. Once these rules are in place, itís important to stay with them. They will keep you from making snap decisions, and playing the odds longer than you should. This is why money management rules are a critical part of any effective trading system.