We discussed about basics of trading in the first part where we understood that risk management and capital protection should be the primary objective of trading. Let us try to learn different mechanism of risk management or money management. This time it is going to be little technical.
Risk/Money management is the secret behind survival and big profits
There are two schools of money management 1) Martingale and 2) Anti-martingale.
- Martingale: Origin of martingale strategy is casino. “HARELO JUGARI BAMNU RAME”, a famous Gujarati saying is the simple explanation of this strategy. Traders’ trade more contracts when they lose and fewer when they win. This strategy is an invitation to a disaster, because there is no guarantee that a winning trade will follow a losing trade. It’s best to leave this strategy to the gamblers.
Idea is to take higher risk every time after losing trade. But I would like to highlight here is that the outcome of trades are random. You do not know at what length trade will result in profit. There is probability that you may loss all your money before you get wining trade.
- Anti-martingale: This is the correct strategy for a money management. Anti-martingale money management will help you to survive because it directs you to trade less when you lose and more when you win. Following are the Anti-martingale money management strategies.
- Fixed risk
- Fixed capital
- Fixed ratio
- Williams fixed risk
- Fixed percentage
- Fixed volatility
Lets look at the few points in deep for a better understanding:
- Fixed risk
Suppose, the trading account’s starting balance is Rs. 100,000 which is divided into 50 units of money, which will make the fixed Rupee risk of Rs. 2000. It means you will trade only those trades that present a rupee risk equal to, or lower than, Rs. 2000.
Number of contracts = Fixed risk / Trade risk
- Fixed Capital
Fixed capital does permit you to trade a minimum of one contract even if your account falls below your fixed unit of capital. You will use the following formula to calculate the number of contracts to trade according to the fixed-capital money management strategy:
Number of contracts = Account balance / Fixed unit of capital per contract
This method provides a simple calculation to tell you how many contracts to trade depending on your account balance and fixed unit of capital.
Both the above methods are an approach that can be used by traders who have a small account. It provides a simple mechanism to build accounts quickly and back off when trouble hits.
As I said in the beginning, it is little technical subject to deal with. I have highlighted the two important points here and whoever is interested to learn more about risk management should read a beautiful book “The Universal Principles of Successful Trading” by Brent Penfold. This article is an abstract of the same book.