One of the most important rules, used by professional traders and investors, is related to money management. More specifically, to the size of the positions one takes. In simple words, it means that we decide upfront how much money to risk per position and we stick to this decision by every trade.
Money management helps us to divide the budget into small pieces so that we risk only one piece at a time. If there are 10.000$ in the account, one way would be to divide it in 100 parts, so that we will always risk just 1%. This means, in case of a loss, the budget will survive and we can go on. Keeping small positions is essential, especially at the beginning, when one is quite new at the financial markets.
Of course, keeping the positions small does not provide the possibility to make a 100% return every week, month or even a year. But let’s be honest, such return is very difficult to achieve without extreme risk. The majority of traders lose their money in less than 6 months. The main reason = too big positions or in other words, no money management. Therefore, give you the possibility to learn from mistakes while taking only small positions. That way, you can stay in the game and constantly improve.
In the financial markets, we always work with probabilities. There are very few things which are certain at the market (unless you are a CEO of a company and you know that tomorrow the company will be taken over…needless to say that in this situation, the CEO’s trading would be illegal).
The aim is to find a method which has relatively high chance for success. Traders are not the only ones who work with probabilities. Casinos focus on it as well. If you are rolling a dice, the result can be a number from 1 to 6. Imagine, there would be a game where we lose only when the result is 1 or 2, in other cases (when we get 3, 4, 5, 6) we win. Hence, there is approximately 67% probability for profit.
Would I bet everything on one attempt, in case I can play as long as I want? Definitely not. It can happen that the result will be exactly 1. Would I play the game at all? Absolutely yes, but I would divide my budget and bet just a small part of it. That way, I give the probability the chance to be there for me and develop to my advantage.
When selling options, the probability is on our side. Does that mean that we cannot be wrong 5 times in a row? No. This can happen. But in the long run, we will win when sticking to our rules.
Money management saves accounts
Some people are not very careful when designing appropriate rules. If there is 10.000$ on the account and you decide to have position of 10% of that, this might bring faster potential profit, but also much higher risk. It can happen that there will be a loss several times in a row because of exceptional circumstances in the market (we will get “1” on a dice, five times in a row). Then, 50% of the account is gone. This can mean the end as it would be very difficult to recover. However, if the position had just been 1%, you would have had a really bad day. It might motivate you to study more, maybe to take a break, but you will survive and go on.
That is why, money management and determining the size of positions is the first rule to survive at the financial markets.
See the next rule and improve your performance.
Did you know? In roulette, the probability for the casino to win is only 52.7%, just enough to win in the long run.