Anyone who wants to make a profit on the stock market must also take into account possible losses. Price fluctuations “in the wrong direction” occur more frequently than some stock market participants would like. Risk and money management should help prevent losses from being sidelined.
Money and risk management: Why we also need it for our psyche in stock market trading
Losses are particularly painful on the stock market and often a problem, especially for those new to the stock market. Because they encourage misconduct, which in many cases leads to even greater losses. Our psyche stands in the way of properly dealing with losses. We want to avoid success and therefore losses at all costs. That is why we find it difficult to admit that we are betting “on the wrong horse”. Two typical behavior patterns are:
- A position is held in spite of losses in the hope that there will be a countermovement that offsets the minus
- It is eagerly bought in order to make a profit elsewhere, which is supposed to compensate for losses
Neither of these are always wrong, but they can still turn out to be disastrous if a trader acts rashly, chooses a position size that is too high and does not pull a rip cord to part with a definitely unsuccessful exposure. That is exactly the reason for risk and money management.
Risk management and diversification
Risk management is initially a very general and overarching term. With regard to financial investments – for example shares – it describes the systematic risk limitation and risk control in the awareness that there are various risks associated with investments. When it comes to stock market investments , diversification or risk spreading is a common risk management strategy for investors. By spreading it across numerous stocks and asset classes, part of the risk may be’ diversified down’. This type of risk management is always recommended and applies both in the long-term and in the short-term perspective and regardless of whether you invest or speculate as an investor. It is a basic principle. Risk and money management in this article, however, relates more to short-term and speculative trading on stock exchanges – trading. That is not to say that it cannot be applied “in the longer term”. It is well known that the boundaries between speculating and investing are fluid.
Why are money management and risk management so important?
Risk and money management are two approaches to keep the risk of loss in stock exchange trading within limits. The basic idea is to outsmart our psyche with clearly defined, sensible “rules of the game” and thereby avoid “excessive” losses. It is about a strategy of only taking (well) calculated risks as a trader and drawing the tear line in good time, instead of being guided by “fear of loss”.
There is not always a clear distinction made between risk management and money management in trading. This involves different starting points, which, however, are not mutually exclusive, but rather belong together. The difference is:
- Risk management refers to limiting losses on a single trade
- Money management aims at the correct position size or number of positions in trades in order to maintain an appropriate relationship between the risk of loss and the chance of profit
This already makes it clear: the combination of both approaches makes sense.
What is Risk Management?
Risk management decides at which prices to sell in order to realize losses or to avoid losses.
Limit losses through stop prices
Losses can occur in a position in two ways. The more comfortable situation is: A profit is not realized in the “hope for even more” and is lost again due to opposing exchange rates. More unpleasant: “real” losses develop due to a different course of the course than expected. In order to limit the losses in both cases, it is advisable to set exit prices at which gains or losses are actually realized. In terms of profit, such an exit price is also known as a profit or price target (take profit), and in terms of loss as a loss limit (stop loss). That is the whole point of risk management in trading.
How do I go about risk management?
The art for traders is to determine the “right” exit rates. There is no general limit and good exit rates are not static either. If there are fundamental changes in the chart technical or fundamental data, an adjustment can be recommended. And a take or stop always depends on what chances of winning still exist and how much loss you can handle.
What is money management?
While risk management takes effect when leaving a position, money management is about the right entry. The trader determines the order of magnitude of trades or security purchases with a view to limiting losses.
Limit losses through the correct use of capital The basic idea is to divide the freely available capital in such a way that, even in the event of losses, enough capital remains for subsequent trades to have a realistic chance of equalizing them again. Colloquially, you could also formulate: it’s about not firing your powder all at once, but also having a second, third or fourth shot free to hit the mark.