Trading is all about risk and money management. First learn how to manage your risk and only then think about profits. Many new traders make the mistake of ignoring money management in the beginning but when they get their fingers burnt, they realize the importance of a good money management system. You don't need to risk all your money on a single trade that you may or may not win. This is permissible in gambling but not in trading. In trading, you learn to survive by placing only a small percentage of your money at risk that is appropriate with the volatility level in the market on a single trade.
Calculating position size under the different money management systems is a tricky stuff. You just need to understand the concept. Trading software packages often include money management calculators with them. Let's discuss some of the different systems. There are more but these are some of the most commonly used by traders. Another thing that you need to keep in mind is that stock trading may require a different money management style as compared to futures trading or forex trading. So you need to understand the concept behind these different money management styles as a trader.
Fixed Fractional System
Fixed Fractional Money Management System is the most basic and the most widely used among the traders. Under this money management system, you limit your risk to a fixed percentage of your trading account. Usually this fixed percentage is between 2% -10%. For more riskier trading strategy, you don't risk more than 2% of your trading account on a single trade and for less riskier trading strategy, you may risk as high as 10% of your trading account. As a rule of thumb, don't risk more than 2% of your trading account on a single trade as long as you don't develop more trading experience.
Fixed Ratio System
The second most basic system is the Fixed Ratio System. It is widely used by options and futures traders. If you want to trade options and futures, just type the name of this money management system on any search engine. You will find the formula.
Now, a money management system that had its origins in gambling and betting but is used by many traders is the Martingale Money Management System. Many traders love to use this system when they start losing. There are many trading systems that use the martingale strategy to recover from a loss. There are a number of forex robots or what you call expert advisors that use this strategy to recover loss. What is this strategy then? Suppose you are trading with $ 2,000. If you make a winning trade, good enough, you again trade with $ 2,000. But suppose you lose. In this case, you double your amount to $ 4,000. Suppose, you win, you will recover the loss on the first trade. But suppose, you lose again. So, you double this amount again to $ 8,000. You keep on doubling until you hit a winner. Pretty risky, huh!
But still there are many traders who use this strategy in their trading system. In theory, as long as you have an infinite amount of money with you, you will always come out ahead. But the problem is most us have only a limited amount of money and we may run out of our money soon before we have a winning trade. A better approach on making a losing trade is to pause and think what went wrong and if you make two losing trades in a row, simply stop trading. Go back to the drawing board and rethink your trading strategy. Practice for sometime on your demo account and again start trading.