Money Management Methods - Stock Index Money Management Strategies

In Indices there are two money management methods commonly used to manage the account capital in a traders account.

The two equity management strategies are:

1. Risk: Reward Ratio

2. Percentage Risk Method

Risk: Reward Ratio

The risk: reward ratios means that as trader you only trade when you are likely to make more profits, for example if you have a risk: reward ratio of 3:1 then it means that you'll only trade when you are likely to make profits 3 times as compared to not making profits.

Or put in another way you're more likely to make 3 times what you risk in a single trade. This means that if you risk $100 then you are likely to make $300 dollar in profit on that trade.

Having a high risk : reward ratio will improve your chances of earning more profit when trading the market, e.g. even if your system win ratio is 50 % or even 30 %, you'll still make profits if you have a good risk: reward ratio just as is shown in the illustration below:

From this example if your trade system win ratio is 50 % and your risk reward is 3:1 then from ten trades that you'll have made your profit would have been $10,000, even if your trading system win rate was lower than this & for example your win rate was 30 % you still would have made a profit of $2,000 from the few winning trades such as shown above.

Percentage Risk Method

This method a indices trader will set a fixed % to risk per trade position, therefore a trader might decide to risk only 2 % per trade, this way their trading risk is always kept to a minimum.

Hence if a stock index trader has got a $50,000 dollar trading account, the amount to risk per trade is about $1,000 dollars, therefore depending on the trade position open a trader will set the stop at this amount of $1,000:

For illustration:

If the trader opens is trading the Italy FTSE MIB 40 or IT 40Cash which has got a pip value of € 1 and one pip move is equal to 1 point then the trader would calculate the percent risk money management depending on the lots opened like as illustrated & displayed and shown below

Example 1:

If the trader opens 1 Lot & 1 point move is equivalent to € 1 which is equal to $1.2, then the trader would calculate the points where to place a stop on their trade such as shown & displayed below:

1 Lot equals € 1 per 1 pip move ($1.2)

$1,000/$1.2 (€ 1 is equal to $1.2) equals 833 points

One would set their stop 833 pips away

Example 2:

3 Lots equals € three per 1 pip move ($3.6)

If the trader opens 3 Lot and 1 point move is equal to € 3 which is equal to $3.6, then the trader would calculate the points where to place a stop on their trade such as shown & displayed below:

$1,000/$3.6 (€ 3 is equal to $3.6) equals 277 points

One would set their stop 277 pips away

Example 3:

5 Lots equals € 5 per 1 pip move ($6)

If the trader opens 5 Lots & 1 point move is equal to € 5 which is equal to $6, then the trader would calculate the points where to place a stop on their trade just as is shown & displayed below:

$1,000/$6 (€ 5 is equal to $6) equals 166 points

One would set their stop 166 pips away

Example 4:

10 Lots equals € 10 per 1 pip move ($12)

If the trader opens 10 Lots & 1 point move is equal to € 10 which is equal to $12, then the trader would calculate the points where to place a stop on their trade such as shown and illustrated below:

$1,000 dollars/$12 (€ 10 is equivalent to $12) equals 83 points

One would set their stoploss 83 pips away

This also means the less the lots a indices trader opens, the more the pips a trader has when it comes to setting the stops. If a trader opens 1 lot then he can set the stop up to 833 pips & still be within the 2 % percent risk rule, while if the trader opens 10 lots then they will have to set the stops at only 83 points away so as to be within the 2 % risk management rule.

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