Understanding the Difference and the Connection
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: Protecting Each Trade
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.
Think of risk management as the strategy you use to safeguard yourself from significant losses on a single trade. It’s about understanding:
- How much you’re willing to lose if things go wrong.
- How likely that loss is, based on market conditions.
- What potential reward you might gain if the trade goes your way.
For example, when you place a stop-loss order at a specific price level to limit how much you could lose, you’re practicing risk management. But there’s more to it than just setting a stop. You need to consider:
- The volatility of the asset: Is it prone to big price swings?
- The market environment: Are you trading in a choppy market or a steady trend?
Let’s say you’re trading a stock that typically moves up or down 10% in a day. Placing your stop just 5% below your entry price might be too tight, as normal market movement could hit it. Instead, you might choose a stop 10% below, allowing room for natural price fluctuations while still capping your risk.
Money Management: Preserving Your Trading Capital
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.
If risk management is about protecting a single trade, money management is about protecting your overall trading account. It ensures that no single bad trade (or string of trades) wipes you out.
The golden rule? Never risk more than a small, predefined percentage of your total trading capital on any one trade. A common guideline is 1-2% of your account balance. For example:
- If you have £10,000 in your trading account and follow the 1% rule, the most you should risk on any trade is £100.
- This doesn’t mean your position size is limited to £100. Instead, it’s the maximum loss you’re willing to accept after factoring in your stop-loss.
By following this rule, you stay in the game even if you hit a rough patch. Imagine losing 10 trades in a row (it happens). If you’ve risked only 1% per trade, your account is down 10%, not 50% or more.
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.
The Relationship Between Risk and Money Management
Smart trading happens at the intersection of risk management and money management. A trade should not only make sense from a risk perspective but also fit within your overall money management rules. Let’s look at a concrete example.
Example: Swing Trading the FTSE 100
The FTSE 100 index has been moving between 4500 and 5000, and you spot an opportunity to buy when the price drops to 4600. Here’s your thought process:
- You plan to set a stop-loss at 4450 (150 points below 4600). If the trade goes against you, your risk is 150 points × £1 per point = £150.
- But your money management rule says you can only risk £100 (1% of your £10,000 account). The £150 risk exceeds this limit.
To resolve this, you could:
- Wait for the price to drop further to 4550, reducing your risk to £100 while keeping the same stop-loss at 4450.
- Reduce your position size to 0.67 per point (£100 ÷ 150 points), though this depends on whether your trading platform allows fractional sizes.
- Adjust your money management rule slightly (e.g., risk 1.5% instead of 1%), though this should be done cautiously.
Risk Management vs. Money Management in Trading: Understanding the Difference and the Connection
If you’ve spent any time reading about trading, you’ve likely come across the terms risk management and money management. At first glance, they might seem like interchangeable buzzwords, but they are distinct concepts that play complementary roles in a successful trading strategy. Let’s break them down in a way that’s clear for beginners and meaningful for seasoned traders.
Risk Management: Protecting Each Trade
Think of risk management as the strategy you use to safeguard yourself from significant losses on a single trade. It’s about understanding:
- How much you’re willing to lose if things go wrong.
- How likely that loss is, based on market conditions.
- What potential reward you might gain if the trade goes your way.
For example, when you place a stop-loss order at a specific price level to limit how much you could lose, you’re practicing risk management. But there’s more to it than just setting a stop. You need to consider:
- The volatility of the asset: Is it prone to big price swings?
- The market environment: Are you trading in a choppy market or a steady trend?
Let’s say you’re trading a stock that typically moves up or down 10% in a day. Placing your stop just 5% below your entry price might be too tight, as normal market movement could hit it. Instead, you might choose a stop 10% below, allowing room for natural price fluctuations while still capping your risk.
Money Management: Preserving Your Trading Capital
If risk management is about protecting a single trade, money management is about protecting your overall trading account. It ensures that no single bad trade (or string of trades) wipes you out.
The golden rule? Never risk more than a small, predefined percentage of your total trading capital on any one trade. A common guideline is 1-2% of your account balance. For example:
- If you have £10,000 in your trading account and follow the 1% rule, the most you should risk on any trade is £100.
- This doesn’t mean your position size is limited to £100. Instead, it’s the maximum loss you’re willing to accept after factoring in your stop-loss.
By following this rule, you stay in the game even if you hit a rough patch. Imagine losing 10 trades in a row (it happens). If you’ve risked only 1% per trade, your account is down 10%, not 50% or more.
The Relationship Between Risk and Money Management
Smart trading happens at the intersection of risk management and money management. A trade should not only make sense from a risk perspective but also fit within your overall money management rules. Let’s look at a concrete example.
Example: Swing Trading the FTSE 100
The FTSE 100 index has been moving between 4500 and 5000, and you spot an opportunity to buy when the price drops to 4600. Here’s your thought process:
- You plan to set a stop-loss at 4450 (150 points below 4600). If the trade goes against you, your risk is 150 points × £1 per point = £150.
- But your money management rule says you can only risk £100 (1% of your £10,000 account). The £150 risk exceeds this limit.
To resolve this, you could:
- Wait for the price to drop further to 4550, reducing your risk to £100 while keeping the same stop-loss at 4450.
- Reduce your position size to 0.67 per point (£100 ÷ 150 points), though this depends on whether your trading platform allows fractional sizes.
- Adjust your money management rule slightly (e.g., risk 1.5% instead of 1%), though this should be done cautiously.
Making It Work in Real Trading
Balancing risk and money management often requires trade-offs. Here are some practical tips:
- Set Realistic Stop-Losses: Avoid setting stops so tight that normal market movements stop you out. At the same time, don’t make them so wide that you risk too much.
- Understand Position Sizing: Use tools or calculators to determine how much of an asset you can buy while staying within your risk limits. For instance, if you want to risk £100 on a trade with a 10-point stop, you can buy 10 units (£100 ÷ 10 points).
- Consider Risk-Reward Ratios: Aim for trades where the potential reward is at least double the risk. For example, risking £100 to make £200 gives you a 2:1 reward-to-risk ratio, which ensures profitability over time, even with a 50% win rate.
Advanced Insight: Position Sizing
If you’re an experienced trader, you’ve likely heard of Van Tharp, a well-known trading educator. He uses the term “position sizing” as a synonym for money management. This involves deciding how much of your capital to allocate to each trade, based on:
- Your risk tolerance.
- The trade’s probability of success.
- Your account size and the overall market environment.
For example, in a highly volatile market, you might size your positions smaller to reduce overall exposure. Conversely, in a trending market, you might size up to capitalize on strong opportunities.
Here is a visual aid that illustrates the relationship between stop-loss levels and position sizes:
- Horizontal Axis: Stop-loss levels in points (the distance between your entry price and stop price).
- Vertical Axis: Position size in units (e.g., £ per point in spread betting).
- Key Observations:
- As the stop-loss level increases (i.e., you’re risking more points per trade), the position size decreases to maintain the same total risk (£100 in this example).
- The red dashed line represents the minimum trade size allowed by many platforms (e.g., £1 per point). Below this, you might not be able to adjust your position size further.
- The green dashed line is an example stop-loss level (100 points), where the corresponding position size would be £1 per point.
This graph demonstrates how to adjust your position size based on your stop-loss, ensuring you stay within your risk tolerance.
Final Thoughts
Risk management and money management are two sides of the same coin. Together, they help you stay disciplined, preserve your capital, and weather the inevitable ups and downs of trading. Whether you’re a beginner learning the ropes or an advanced trader refining your strategy, mastering these principles is key to long-term success.
