Many traders overlook the importance of money management but it is a key component in determining your trading success. Money management refers to the process of analysing trades for risk and potential profits and managing trades to ensure trading longevity and maximise profitability. The important role money management plays is best illustrated through drawdown analysis.
Drawdown refers to the amount of money that is lost trading, expressed as a percentage of your total trading capital. If every trade you took was profitable, your account would never experience a drawdown. Drawdown measures the money that is lost while trading but does not measure the overall performance. Drawdown is calculated when a trader experiences a losing trade and continues as the trading account hits new equity lows.
Assuming you start trading with $10,000 capital and your first trade incurs a $1,000 loss your drawdown is 10%. You place another trade with your remaining $9,000 capital and achieve a $1,000 gain then a further $2,000 loss, your capital is now $8,000 so your drawdown would be 20%.
($10,000 – $1,000 +$1,000 – $2,000) = $8,000 a 20% loss on the $10,000 capital.
Maximum drawdown is the amount of money that is lost prior to getting back to break even. If you began with $10,000 and lose $3,000 before getting back to break even, your maximum
drawdown would be 30%. The process of recouping drawdowns is referred to as drawdown recovery which becomes increasingly difficult as drawdowns increase.
Drawdown recovery highlights the importance of intelligent money management and refers to the percentage gain necessary to recover from any drawdown. If you experience a 20% drawdown you need to make 25% (not 20%) profit to break even.
As the drawdown increases the percentage gain needed to recover the loss increases rapidly as illustrated in the following table.
Trading in CFDs requires astute money management to be successful in the long term. As a trader your ability to collate, retain and use your knowledge and trading information will increase your likelihood of trading successfully. The traders who tend to enjoy the greatest sustained success are those who stick to predetermined, clearly defined rules.
We will look at three money management rules you should incorporate into your trading: