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Lesson 12 – Money Management
Written on 10 November 2008 by Rod
Money management is part and parcel of any trading strategy. Besides knowing which currencies to trade and recognizing entry and exit signals, the successful trader has to manage his resources and integrate money management into his trading plan. Position size, margin, recent profits and losses, and contingency plans all need to be considered before entering the market.
There are various strategies for approaching money management. Many of them rely on the calculation of core equity.
- Core equity is your starting balance minus the money used in open positions. If the starting balance is $ 20,000 and you have $ 2,000 in open positions your core equity is $ 18,000.
- When entering a position try to limit risk to 1% to 3% of each trade. (If it happens to be a GREAT trade you may once in a while use a 5%, but not more). This means that if you are trading a standard FOREX account with lots of $ 100,000 you should limit your risk to $ 1,000 to $ 3,000 (preferably $ 1,000).
- You do this by placing a stop loss order 100 pips (when 1 pip = $10) above or below your entry position.
- As your core equity rises or falls you can adjust the dollar amount of your risk. With a starting balance of $10,000 and one open position your core equity is $9,000. If you wish to add a second open position, your core equity would fall to $8,000 and you should limit your risk to $900. Risk in a third position should be limited to $800.
- By the same principal you can also raise your risk level as your core equity rises. If you have been trading successfully and made a $5,000 profit, your core equity is now $15,000. You could raise your risk to $150 per transaction. Alternatively, you could risk more from the profit than from the original starting balance.
This is known as the Anti-Martingale Strategy. To understand this strategy we will explain the Martingale Strategy before.
Martingale Strategy
In a few words this strategy looks to increase the risk when losing.
This is a startegy adopted by gamblers which claims that you should increase the size of you trades when losing. It’s applied in gambling in the following way: Bet $100, if you lose bet $200,if you lose bet $400,if you lose bet $800,if you lose bet $1,600 and so on.
This strategy assumes that after 4 or 5 losing trades, your probabilities to win is bigger so you should add more money to recover your loss! The truth is that the odds are same in spite of your previous loss! If you have 5 losses in a row ,still your odds for 6th bet 50% and 50%.
The same fatal mistake can be made by some novice traders. For example,if a trader started with a abalance of $10,000 and after 4 losing trades (each is $1,000) his balance is $6,000. The trader will think that he has higher chances of winning the 5th trade then he will increase ths size of his position 4 times to recover his loss. If he lose,his balance will be 2,000$!! He will never recover from 2,000$ to his startiing balance 10,000$. A disciplined trader should never use such gambling method unless he wants to lose his money in a short time.
Anti-Martingale Strategy
In a few words, this strategy tries to increase risk when winning and decrease risk when losing
It means that the trader should adjust the size of his positions according to his new gains or losses.
Example: One Trader starts with a balance of $10,000.
His standard trade size is $1,000
After 6 months,his balance is $15,000.
He should adjust his trade size to $1,500.
On the other hand, another trader starts with $10,000.
His standard trade size is $1,000.
After 6 months his balance is $8,000.
He should adjust his trade size to $800.
There are several rules of good money management:
1. Risk only small percentage of total account
The main idea of the whole trading process is to survive! Survival first, and only then making money on top.
One should clearly understand, that Big traders first of all are skillful survivors. In addition, they usually have deep pockets, which means that under unfavorable conditions they are financially able to sustain big losses and continue trading. For the ordinary traders, the majority of us, the skills of surviving become a vital “must know” platform to keep trading accounts alive and, of course, to make good stable profits.
2. Calculate risk / reward ratio before entering a trade
When chances to win in a trade are smaller than potential losses, don’t trade! Remember that staying aside is a position.
For example: 40 pips to lose versus 30 pips to win, 20 pips to lose versus 20 pips to win. All these examples are a clear sign of bad risk management.
Before entering each trade, reassure that risk / reward ratio is at least 1:2 (better yet 1:3), which means that chances to lose are 2 times less than promises to win.
For example: 30 pips of possible loss versus 100 pips of potential win is a good trade to consider entering.
Adopting this money management rule as a must, in the long run will dramatically increase trader’s chances to succeed in making stable gains.
3. Learn to use protective stops
Many traders have a problem defining where they should place their stop loss. They have no problem entering a trade but often have a problem defining where they should take profits or cut their loses. In this lesson we will cover some of the popular methods of choosing a stop loss.
1. Dollar value.
2. Support and Resistance.
3. Fibonacci Retracements.
Dollar Value
A lot will also depend on your trading time frame but for this example, a 4 hour chart will be used. A trader using a dollar value stop loss will place his stop loss (stop) a given number of dollars away from where he entered the market.
In the example of GBP/USD the trader enters the market long at 1.8500 on the breakout of resistance at 1.8510. He determines that he will use a dollar value as his stop of $300. This makes his stop level of 1.8470 (30 pips at $10 per pip). If the market should retrace 30 pips or more then his stop will be hit and he will be out of the market.
You may find that by using this method you are taken out to frequently only to find the market taking off in the direction of the original trade. The best way to overcome this is to do some back testing to find the best amount for the market you are trading. The advantage is that is easy to implement. There is no working out of figures or levels and you can place your stop as soon as you get into the market.
Support and Resistance
When using support or resistance for placing a stop a trader will first determine where they will get into the market and if long will then place their stop under the nearest support. If they are short they will place the stop above the nearest resistance.
In the case of the EUR/USD the trader goes long at 1.0750 which a break of resistance at 1.0746 and places his stop at 1.0680, which is a few pips away from support at 1.0683. Although the break of the resistance level of 1.0746 should eventually become support when you enter a trade you don’t know if the break is real or false so the safer place is the most recent support.
This method, may be very logical but the distance between where you enter the market and where you can place your stop may be so large that the dollar amount would put your account in jeopardy. The way round this would be to only take trades that fitted in with your level of risk and personality.
Fibonacci Retracements
When using fibonacci to place your stop you would first measure the move and in the case of the USD/JPY the move was from 117.85 to 119.52. This gave us three retracement levels 118.88 (38.2%), 118.68 (50%) and 118.49 (61.8%). In this example the trader entered the market slightly ahead of the 38.2% at 118.90 and placed his stop at 118.45 just below the 61.8% retracement. He could just as easily have used the 50% retracement depending on the market and market conditions.
This method is very adaptable but can also mean that your stop is so far away that your dollar risk could be too large. The alternative could be to use the 50% retracement instead of the 61.8% retracement to place your stop. The advantage is that fibonacci retracement can be very accurate.
The three methods are not all the ways to place a stop loss but they are the most common. The question you are probably asking now is which method is the best. Well, there is no right answer to this, it depends on many factors such as account size personal preference and what method you have back tested for optimal results. In the case of the dollar value method the disadvantage is that the dollar amount may no be logical for the market conditions.
There is no reason why you can not use all three methods and use a particular stop loss placement depending on market conditions. You will also find that you will probably have a particular method that you prefer. First back test each method then find the one that most suits your trading style and fits in with your risk tolerance.
Diversification
Trading one currnecy pair will generate few entry signals. It would be better to diversify your trades between several currencies. If you have $100,000 balance and you have open position with $10,000 then your core equity is $90,000. If you want to enter a second position then you should calculate 1% risk of your core equity not of your starting balance! It means that the second trade risk should never be more than $900. If you want to enter a 3rd position and your core equity is $80,000 then the risk per 3rd trade should not exceed $800
It’s important that you diversify your trades between currencies that have low correlation.
For example, If you have long EUR/USD then you shouldn’t long GBP/USD since they have high correlation. If you have long EUR/USD and GBP/USD positions and risking 3% per trade then your risk is 6% since the trades will tend to end in same direction.
If you want to trade both EUR/USD and GBP/USD and your standard position size from your money management is $10,000 (1% risk rule) then you can trade $5,000 EUR/USD and $5,000 GBP/USD. In this way, you will be risking 0.5% on each position.
As a final note, please remember that it is much more hard to get back from a loss due to the higher percentage needed. This chart explaines more detailed this:
Amount of Equity Lost Amount of Return Necessary to Restore to Original Equity Value
25% 33%
50% 100%
75% 400%
90% 1,000%