Capital management refers to the process of allocating and managing financial resources in a way that optimises return while minimising risk. In other words, it is about finding the right balance between risk and reward.
There are two main reasons why capital management is so essential for traders:
- It helps to protect your trading account from excessive losses; and
- It enables you to maximise your profits.
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How can traders use capital management in their trading?
One of the most important aspects of capital management is risk management. It involves setting clear limits on the amount of capital you are willing to risk on any trade. For example, if you have an SGD10,000 trading account, you might set a limit of SGD200 per trade. If your trade loses, your account will only be down by 2%.
There are two main ways to manage risk:
- Position sizing refers to the number of contracts or shares you trade. If you are trading ten contracts and each contract is worth SGD10, then your position size is SGD100.
- Stop-loss orders are orders to sell a security when it reaches a specific price. Traders use them to limit losses in a trade. For example, if you buy a stock at SGD100 and place a stop-loss order at SGD90, your maximum loss will be SGD10 per share.
Money management is another important aspect of capital management, referring to managing your money to maximise your profits and minimise losses.
There are three principal money management techniques that traders use:
- The risk-reward ratio is the ratio of the potential profit to the potential loss on a trade. For example, if the potential profit is SGD100 and the potential loss is SGD50, the risk-reward ratio is 1:2.
- Position sizing is the number of contracts or shares you trade.
- Trailing stop-loss orders are orders to sell a security when it reaches a specific price. Traders use them to lock in profits and limit losses in a trade. For example, if you buy a stock at SGD100 and place a trailing stop-loss order at SGD90, your maximum loss will be SGD10 per share.
Asset allocation is another important aspect of capital management and refers to investing your money in different asset classes, such as stocks, bonds, and cash. Asset allocation allows you to diversify your investment so that you are not overly exposed to any asset class.
For example, if you invest all of your money in stocks, you are taking on more risk than if you invest in a mix of stocks and bonds. On the other hand, if you invest all of your money in cash, you are not taking on enough risk to achieve your financial goals.
Portfolio management involves managing your investment portfolio to achieve your financial goals. There are two main types of portfolio management:
- Active portfolio management refers to actively buying and selling securities in your portfolio to generate profits.
- Passive portfolio management refers to holding securities for an extended period and not selling them unless there is a change in your investment goals.
Tax planning is another important aspect of capital management and refers to minimising your tax liability so that you can keep more of your money.
There are two main ways to minimise your tax liability:
- Investing in tax-advantaged accounts is investing in accounts such as a 401(k) or an IRA.
- Selling losing investments refers to selling investments that have lost money so that you can offset your capital gains.
Estate planning is the process of planning for the transfer of your assets after you die. It is essential because it allows you to control how your assets are distributed and minimise the taxes your heirs will have to pay.
There are three main aspects of estate planning:
- Wills are legal documents that specify how you want your assets to be distributed after you die.
- Trusts are legal entities that hold your assets and distribute them according to your wishes.
- Beneficiary designations are provisions in a contract that specifies who will receive your assets after you die.