Money Management
Risk-Reward Ratio Calculations for Traders
A ratio used by traders to compare the expected returns of a trade to the amount of risk undertaken in order to capture these returns.
Calculating a risk/reward ratio for prospective commodity trades should be an integral part of your overall trading plan. Many novice traders make the mistake of only calculating the potential rewards of a trade.
This is great if the trade goes your way. If it doesn’t, as is very likely, you stand to lose heartily – because you haven't set an exit point based upon an analysis of risk.
Risk/reward analysis essentially falls under the trade selection process of a trading plan because if a potential trading opportunity doesn’t meet the ratio it should be discarded as a possible trade. However, it can also placed under the money management part of an overall trading plan since it deals with defining risk levels. I typically consider it part of my trade selection process because it deals with weeding out good and bad trades rather than dictating how much capital to allocate and commit for trading. In either case, it is a necessary step in your trading plan.
Futures Trading – Money Management Basics
Money management rules can be as complex or simple as you would like. Many traders use highly elaborate formulas for calculating risk levels and asset allocation that serve them very well. However, don’t think that it is necessary to create a complex money management plan in order to profit – it isn’t. The degree of complexity is up to you, but simplicity of form is often best because it is more easily understood and executed.
The Dangers of Undercapitalized Trading
Commodity futures trading offers the potential of immense rewards with only a small amount of capital. This is what lures many traders into the markets.
However, it is a rarity for someone to turn, say $1,000-2,000, into a large amount of money without suffering drawdowns or price movements that erase their entire capital very quickly. The few lucky souls that have achieved this are few and far between and I doubt that their success happened overnight.
Indeed, it probably had nothing to do with luck. I suspect that they had rock-solid discipline, were well-informed, and selected trades very carefully. But, more importantly, they most definitely employed very rigid methods of risk management from the very outset of their trading.
