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Money Management

Money Management Services

Money management services offered by financial market brokers and trading platforms is essential for the trader to be profitable.

Investment bankers have trading limits, capital allocated to them before they begin trading. The bank’s treasury department and risk management team decides the allocation of funds into various markets based on multiple criteria such as the return on investment, capital adequacy requirements etc.

However for retail traders, one needs to determine how of the portfolio traders need to allocate in a diversified portfolio of FX, stocks, futures, fixed income and cash or deposits.

In this article, we discuss money management pertaining to financial market trading i.e. specifically how much should one allocate to each trade. In the FX market, if an interbank trader has a daily limit of say 10 million USD and an overnight limit of 4 million USD should the trader take few large positions of say 5 million each and wait and watch? What happens when banks and corporates ask for prices? He would need to cover that back to back and square positions immediately. Instead, should he allocate say 5 million for long positions and 5 million for intraday trading? For retail traders simple decisions of whether to allocate one’s entire funds in trading or a part of it and how much are all issues that need to be addressed.

Money Management Basics

Let’s start with the trader’s total funds. For retail traders, the general guidelines are to split the funds into risky assets and cash. By cash, we mean deposits or any safe highly liquid asset such as treasury bills. Therefore if the amount allocated for investing/trading is 100,000 USD then 50,000 should be kept as a reserve for drawdowns and 50,000 for trading purpose. It is also recommended to restrict total amounts in a single investment category capped at roughly 20% of capital.

Of the 100,000 kept aside for trading, the trader needs to decide on the markets you wish to trade. If the trader is trading in FX, stocks, and futures then we know that only stocks can be taken delivery of. FX and futures are speculative and margin money needs to be kept aside. 10-15% of funds for margin money in a single market should be sufficient. So for the FX market that would translate to 10-15k as margin money. If the FX broker provides a 100:1 leverage the trader could take up to 1 to 1.5 million dollars in position.

However, on a 1 million position the 10k margin money is nothing and can get wiped out in a few trades. The max stop loss placed on a single trade is generally recommended at 5% of the total consideration. In this example, the trader should not risk more than $5000 in a single position.

Let’s summarise the general guideline here. However every trader’s risk appetite is different, so while these are simple guidelines that one could follow the more aggressive a trader larger would be his positions.

Investment Capital

100000

Markets

FX

Stocks

Commodities

Cash

margin/investment

10000

10000

cap

20000

20000

20000

40000

leverage

100:1

value of contract/margin requirement

max position based on leverage

1000000

number of contracts traded will depend on the size of the contract

max stop loss per trade 5%

5000

For 4 trades 0.25 mil each max S/L

1250

number of pips in USDJPY for 0.25 mil position

0.565

We see a simple example of a trader who has an initial capital of a $100,000. Let us assume the trader wishes to diversify into the following markets – FX, stocks, and commodities. Using the general guideline of limiting the total amount invested in a single market at 20%, that leaves the trader to invest $20,000 in each of the 3 markets and $40,000 in cash. Let’s discuss how the trader can manage his or her money in the FX markets. Assume the trader wishes to start with only $10,000 as initial margin. If the trader finds a broker who is willing to provide a 100:1 leverage, the trader can take positions up to a $1 million. If the trader wishes to trade $1 million positions the trader would get stopped out quickly with a $10,000 margin. The trader could easily calculate the number of pips as

10,000 x 113.00 / position size of 1000000 = 56 to 57 pips in USDJPY

The trader has multiple options here – either take 1 million dollar positions with a stop loss at 56 pips. This is a very tight stop that could wipe out the entire margin deposit. Better still would be to take 2 half million dollar positions with same stops. However, the advantage here is that the trader could use one half million positions for running the position for the long term and leave trailing stops. Use the second position to play intraday making multiple trades with tight stops and small profits. Considering the market statistic of the best traders winning only 40% of trades its prudent for traders to keep profits running and stops small. The risk-reward ratio commonly used is 3:1, which means for a 10 pip stop loss the profit should at least be 30 pips.  By splitting the total position one wishes to trade to 2 or 4 positions of a half to quarter million dollars gives the trader the flexibility to run some of the positions and trade the other on a shorter term basis.

One should remember that these are only guidelines. As the trader gains more experience in trading, the trader can tweak his or her strategies based on what works best for the trader.

The trader needs to incorporate all the best practices learned so far in their daily study of charts

  • What are the long-term charts such as the weekly monthly charts indicating?
  • Identify the major, intermediate, minor trends
  • Draw all the important support, resistance, trend lines, channels
  • Study volume and open interest if available. Else one could look at the futures market as discussed
  • Enter on retracements – one third, half and two-thirds
  • Use Fibonacci numbers as retracements
  • Use speed lines and the 45% line to determine the sustainability of the trend
  • Identify continuation or reversal patterns
  • Use all strategies discussed for trading breakouts
  • Determine minimum price objectives
  • Check oscillators for overbought and oversold regions and divergences
  • If the market is too bearish or bullish look for contrarian trades
  • Use fundamentals to determine the sentiment of the markets, central banks. Economic indicators calendar provides important clues to what markets are waiting. A possible rate hike by the Fed could give USDJPY the necessary boost to breakout from a consolidation pattern.

 

For a full course on the strategies investment bankers use for trading technical analysis and fundamental analysis, you could take the InvestopediaPro’s courses. Check out our Courses page for full details.

Alternatively continue to browse this site for more topics on Fundamental Analysis.

Related Topics

Price Determinants of Financial Instruments

Technical Analysis of Financial Markets

Online Courses – Fast Track Your Learning

 

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