How personal money management works: In the markets it`s possible to be right, and to still lose money. In fact, it`s pretty common. Traders who win on a high percentage of their trades often end up with their capital eaten away, and nothing to show for their work. They lose their gains because they don`t know how to manage their money.
Being a good manager of your own money is one of the most difficult trading skills to learn. But if you don`t use good personal money management to lock in profits, take small losses on the picks you`re wrong about, and control your use of margin, eventually you`ll lose everything, no matter how good of a trader you are. You need to make protecting your capital your first priority if you want to be successful.
As a trader, your capital is the most valuable thing you have. Without it, you can`t trade at all. For this reason, bringing in no profits on a trade is better than losing any part of your capital. If your account is intact, you can always make a profit another day. If your capital has suffered a loss, you`ll be wasting effort playing catch-up. The more you`ve lost, the longer it will take to get back to where you started from, because you`ve got more to make up for, and because you`ll have a smaller chunk of capital to work with. A smaller capital base means smaller percentage returns on profits. Making 10% on a $10,000 account earns you $1,000, but if you`ve lost half of that account and have only $5,000 left, making 10% on your money will earn you only $500. You`d have to do that twice to make the same $1,000.
Sound personal money management has two main goals: to avoid losing money, and to avoid missing profit opportunities by tying up capital in problem trades for long periods of time. Failing to avoid either of these will cost you. The first goal is straightforward. You want to preserve your capital and whatever profits you`ve accumulated. But you don`t just want to keep your capital, you want to trade with it as well, to continue to grow it and make your returns larger and larger.
Working to avoid losing those profit making opportunities isn`t quite as obvious a goal. With the second goal in mind let`s compare the outcomes of two money-management decisions. Trader A buys a stock, expecting it to go up, and finds that it doesn`t. However, he`s certain it will go up eventually, and he`s incurred a small loss, so he decides to wait it out. He ends up holding the stock for three months before finally selling it. Trader B buys the same stock at the same time as Trader A, but once he sees that it isn`t going up, he sells it at a small loss. He buys another stock and makes a 15% profit on it. His next trade loses 1%, but after that he makes 8 %, 15%, and 30% on a series of trades. Because he is growing his account, he makes these percentages on a larger and larger base of capital each time. At the end of three months, his account has grown by 48%.
Whose personal money management decision turned out to be the best? While Trader B made a nice profit, Trader A not only lost time but also never made his money back. Even if he had made his money back on that stock, it`s hard to see how this was a good use of his capital over the course of three months.
Clearly the goal of not tying up your capital in problem trades has an important impact on your profits. Practising sound personal money management will keep your capital and your profits safe. Though it is a difficult skill to learn, once you know how to practise good personal money management, you can almost guarantee that you will be a success as a trader.
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