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Implementing Money Management Techniques
Implementing sound money management encompasses many techniques and skills intertwined by the trader’s judgment. All three of these ingredients must be in place before the trader is said to be using a money management program along with their trading. Failure to implement a good money management program will leave the trader subject to the deadly “risk-of-ruin” exposure leading eventually to a probable equity bust.
Whenever I hear of a trade making a huge killing in the market on a relatively small or average trading account, I know the trader was most likely not implementing sound money management. In cases such as this, the trader more than likely exposed themselves to obscene risk because of an abnormally high “Trade Size.” In this case the trader or gambler may have gotten lucky leading to a profit windfall. If this trader continues trading in this manner, probabilities indicate that it is just a matter of time before huge losses dwarf the wins, and/or eventually lead to a probable equity bust or total loss.
Whenever I hear of a trader trading the same number of shares or contracts on every trade, I know that this trader is not calculating their maximum “Trade Size.” If they where, then the “Trade Size” would change from time to time when trading.
In order to implement a money management program to help reduce your risk exposure, you must first believe that you need to implement this sort of program. Usually this belief comes after having a few large losses that cause enough psychological pain that you want and need to change. You need to understand how improper “Trade Size” actually will hurt your trading.
Novice traders tend to focus on the trade outcome as only winning and therefore do not think about risk. Professional traders focus on the risk and take the trade based on a favorable outcome. Thus, “The Psychology Behind ‘Trade Size’” begins when you believe and acknowledge that each trade’s outcome is unknown when entering the trade. Believing this makes you ask yourself, how much can I afford to lose on this trade and not fall prey to the “risk-of-ruin” outcome?
When traders ask themselves that, they will then either adjust their “Trade Size” or tighten their stop-loss before entering the trade. In most situations, the best method it to adjust your “Trade Size” and set your stop-loss based on market dynamics.
During “draw-down” periods, risk control becomes very important and since good traders test their trading systems, they have a good idea of the probabilities of how many consecutive losses in a row can occur. Taking this information into account, allows the trader to further determine the appropriate risk percentage to take on each trade.
Let’s talk about implementing sound money management in your trading formula so as to improve your trading and help control risk. The idea behind money management is that given enough time, even the best trading systems will only be right about 60% to 65% of the time. That means 40% of the time we will be wrong and have losing trades. For every 10 trades, we will lose an average of 4 times. Even trading systems or certain trading set ups with higher rates of returns nearing 80% usually fall back to a realistic 60% to 65% return when actually traded. The reason for this is that human beings trade trading systems. And when human beings get involved, the rates of returns on most trading systems are lowered. Why? Because humans make trading mistakes, and are subject from time to time to emotional trading errors. That is what the reality is and what research indicates with good quality trading systems traded by experienced traders.
If we are losing 40% of the time then we need to control risk! This is done through implementing stops and controlling position size. We never really know which trades will be profitable. As a result, we have to control risk on every trade regardless of how sure we think the trade will be. If our winning trades are higher than our losing trades, we can do very well with a 60% trading system win to loss ratio. In fact with risk control, we can sustain multiple losses in a row without it devastating our trading account and our emotions.
Some traders can start and end their trading careers in just one month! By not controlling risk and by using improper “Trade Size” a trader can go broke in no time. It usually happens like this; they begin trading, get five losses in a row, don’t use proper position size and don’t cut their losses soon enough. After five devastating losses in a row, they’re trading capital is now too low to continue trading. It can happen that quickly!
It is equally important that the trader is comfortable with their trading system and have the knowledge to know that it is possible and inevitable to have a losing streak of five losses in a row. This is called drawdown. Knowing this eventuality prepares the trader to control their risk and not abandon their chosen trading system when it occurs. It is another ingredient in “The Trader’s Mindset.”
What we are striving for is a balanced growth in the trader’s equity curve over time.
Below is a list of the ingredients in devising a sound money management plan for your trading:
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- Always use stops
- Determine your “Trade Size” based on your trading account equity, your stop loss price for every trade
- Never exceed a loss of 2% on any given trade
- Never trade more than 2% on any give sector
- Never exceed a total portfolio risk of 6%
- Always trade with risk capital, money you can afford to lose
- Never trade with borrowed money
- Don’t overtrade based on the time frame you have chosen to trade
“Trade Size” And The 2% Risk Rule
The two percent risk rule along with the six percent portfolio risk rule are shown to keep a trader out of trouble provided their trading system can produce 55% or above win to loss ratio with an average win of at least 1.6 to 1.0 meaning wins are 60% larger than loses. So, for every dollar you lose when you have a losing trade, your winning trades produce a dollar and sixty cents.
Assuming the above, we can then proceed to calculate risk. The two percent risk is calculated by knowing your trade entry price and your initial stop loss exit price. The difference of the two gives you a number that when multiplied by your position size (shares or contracts) will give you your dollar loss if you are stopped out. That dollar loss must be no larger than two percent of the equity in your trading account. It has nothing to do with leverage, and in fact you can use leverage and still stay within a two percent risk of equity in your trading account.
Money Management Example
Calculating The Dollar Amount Of Two Percent Risk:
Trading Account Equity: $ 25,000
2% of $ 25,000 (Trading Account Equity) = $ 500
Assuming no slippage in this example
Thus on any given trade you should risk no more than $500 net which includes commission and slippage.
Actual Example In The Market Place:
MSFT is currently trading at $60.00 per share
Round trip commission is $ 80.00
Our trading system says to go long now at $ 60.00 per share. Our initial stop loss is at $ 58.50 and the difference between our entry at $ 60.00 and our initial stop loss at $58.50 is $ 1.50 per share.
Now the question is how many shares (“Trade Size”) can we buy when our risk is $ 1.50 per share and our two percent account risk is $ 500.00?
- $ 500.00 minus $ 80.00 (commissions) = $ 420.00
- $ 420.00 divided by $ 1.50 (initial stop loss amount) = 280 shares
That means you should buy no more than 280 shares of the stock MSFT to maintain proper risk control and obey the 2% risk rule. If you trade future contracts or option contracts, you calculate your position size the same way. Note that your “Trade Size” may be capped by the margin allowances for futures traders and for stock traders.
Note that MSFT which is Microsoft is a technology company in the technology sector. It is important that if you want to take another trade while you are still in the Microsoft trade, that you trade a different sector of the market. This same rule applies to options and futures as well. In futures trade a different commodity. So, basically using these rules you will be automatically diversified.
Also note that if your risk in one sector is only one percent, you may take additional trades in that sector until you reach a total of two percent. You should not exceed six percent overall between all sectors. In other words, the most or total account portfolio risk you should have at any given time should not exceed six percent. Remember the two percent risk must include commissions and if possible slippage, if you can determine that. Using this technique will also keep your trade and risk in proportion to your trading account size at all times.
If you do not add-on to a current position, but your stop moves up along with your trade, then you are locking in profits. When you lock in profits with a new trailing stop, your risk on this profitable trade is no longer 2%. Thus, you may now trade another market. So, multiple positions can be possible.
Trading Capital – Funding Your Trading Account
It is alarming that many traders use either borrowed money or money they really cannot afford to lose or risk. This usually will set the trader up for failure because they will be subject to the market’s emotional manipulation since the trader cares too much about the outcome of each trade.
In simpler terms, the trader is nervous about losing the money and therefore each stop out creates more anxiety up to a point where the trader may not want to get out when suppose to and take the loss, but instead hope the trade comes back. It takes both responsibility and discipline for accepting the trading loss and getting out. This is the same type responsibility and discipline the trader did not have when he or she decided to trade with money that shouldn’t be traded. So, it is not likely the trader will have the discipline nor have the responsibility to trade successfully. If you do not have sufficient risk capital to trade, begin “Paper Trading” to improve your trading skills while you are saving enough risk capital to begin trading with real money. This way when you are ready to trade with real money you will have practiced your trading skills so that you will do better.
The Psychology Behind “Scaling” Out Of Trades
“Scaling” out of trades can be incorporated into your money management game plan since it is a component of risk control.
“Scaling” out of trades is a great technique that actually can convert some losing trades into profitable ones, reduce stress, and increase your bottom line! As you all know by now, I am a big advocate of reducing stress while you’re in a trade. This way you can focus on the trade and not be subject to emotions such as fear and greed which usually hamper your trading. Properly “Scaling” out of positions can not only at times make you more profitable, but it can also reduce the stress that some traders incur during trading.
In order to “Scale” out of trades the initial “trade size” must be large enough so you can reap the benefits of “scaling.” The technique is applicable for both long and short positions, and for all types of markets like futures, stocks, indexes, options, etc. The key here is that the initial position must be large enough to enable you to cover your profitable trade in increments without incurring additional risk form such a large opening position. Remember, we want less stress, not more!
Your initial position or “trade size” should always be within a 2% risk parameter. Therefore, the key now is be able to initiate a large enough “trade size” while not risking more than 2% on entering the trade. There is only two ways to do this. One way is to find a market that you can initiate a large enough “trade size” with your current trading account size based on a 2% or less loss if this initial position is stopped out. The other way, is to add additional trading capitol to your trading account that will allow for a larger position because 2% of a larger account allows for a larger “trade size.” There is even another way, and that is to use the leverage of options, but you must be familiar with options, their “time value” decay, delta, etc. Using options would be considered a specialty or advanced technique, and if you are not familiar with them, this method could lead to increasing your stress!
Here is an overview of “scaling” out of a position and how it can help your trading. This technique works on all time frames from intra-day to long-term term monthly charts!
“Scaling” Out Example
Let’s choose the e-mini as an example. In our example, your account size is $25,000 and you choose to risk 2% on this trade. 2% of $25,000 is $500. Your trade entry is 1037.75 and your exit is 1036.25 so you can buy approximately 6 contracts and stay within your risk parameters. Now this means if you get stopped out before having a chance to “scale” out, your loss would only be 2% which is acceptable from a “risk-of-ruin” stand point and therefore, this potential risk should not create any stress. Note, that if you add risk capitol to this trading account, you would be able to increase your initial “trade size” and still maintain a 2% risk. Let’s say we enter this trade and it starts to become profitable. Here is where “scaling” out comes in and there are many variations to “scaling” out, so you will need to “paper trade” this technique to find which way works best for you. The idea is, as soon as the trade is profitable enough, cover part of your position and liquidate enough contracts so that if you are still stopped out, you make a small profit! If the trade becomes even more profitable, then you may want to liquate some more contracts to lock in more profit as well. The idea here is that as soon as your trade is profitable enough; liquidate enough contracts so that even if your original stop-loss is triggered, you make a profit. If your initial stop-loss is never triggered, then you should be able enjoy the rest of the trade and let it go as long as the trend takes it knowing that no matter what happens, you should at least make a profit on this trade. Knowing this is a great feeling and you will even have more fun trading!
There are many variations and themes on how to “scale” out, but this is the basic idea. If you trade only one or two contracts you really can’t “scale” out of positions that well. This is another reason why larger trading accounts have an advantage over smaller ones! Also, some markets are more expensive then others, so the cost of the trade will also determine your “trade size.” Remember in choosing your market, liquidity is important, and you must have sufficient market liquidity as well to execute “scaling” out of positions in a meaningful way. Poor fills due to poor liquidity can adversely effect our “scaling” out technique.
The psychology behind “scaling” out is to reduce stress by quickly locking in a profit, which should also help you stay in trends longer with the remaining positions.
Here is an example of using multiple money management techniques. In the chart below we adjust stops and “scale” out of the trade in increments as part of our money management program. The initial “trade size” was calculated using a 2% risk based on the trade entry and the initial stop-loss point as indicated on the chart.
Money Management in Forex: More Than Just Trading
Introduction: Money Management in Forex
In this article, you’re going to learn everything you need to know about money management in forex.
We have discussed all the angles on and the importance of Stop Losses in the articles called “The Ultimate Guide On Stop Losses”, click here for Part 1 and click here for Part 2. If you have not read that guide, make sure to take a look!
Of course, the stop loss is just a part of the entire equation in our world of Forex trading. Here, we are going to continue with this material, but we are going to look at a broader topic: Money Management (MM). MM is, of course, a vital topic, and is of equal importance as Risk Management, Trading Strategies, Trading Psychology, and Trade Management.
What is Money Management?
Let us start with the question: what is basic Money Management? The core goal of successful money management is maximizing every winning trades and minimizing losses. A master of money management is a master Forex trader. Money management is a method to deal with the issue of how much risk should the decision-maker/trader takes in situations where uncertainty is present.
You might ask yourself, isn’t basic money management the same as risk management?
Risk management, in fact, is your choice of how much risk you want to place on a trade.
You are always in control of how much risk you place on a trade: whether that it is 1% or $100, but I would recommend using a standard % risk (not $) of your designated trading capital. Every trader’s first goal is to preserve the trading capital, which is achieved by being very disciplined in the field of risk management.
In Money Management every trader is actually looking at the reward to risk ratio, or R: R ratio in short. Money management calculates the balance between the risk and the reward of the trade. In Money Management, the following definitions are vital:
- The risk is the stop loss size (discussed in previous articles).
- The reward is the profit potential (take profit minus entry).
How many pips a Forex trader has earned is really not of much value, unless the pips risk is mentioned as well. Anyhow, it would be better to focus on the Rate of Return % and $/money earned. This is what all businesses do and all of us should treat trading as a business.
Reward to Risk Ratio
The ratio between the two is crucial. A trader that targets a quarter of the risk has just won one “battle” but has just lost the “war”. In trading terminology, this means that a trader might have won a trade, but ultimately the win means nothing and that Money Management has set them up for failure. Why?
For a trader to become long-term profitable with a 0.25 reward to risk ratio, the trader would need to win 4 trades to compensate 1 loss. With this equation, the trader has not made any profit. Of course this R: R makes no sense: a trader needs to get above the 80% win % to achieve profit. Not an easy feat.
With a 1:1 Reward to risk the trader only needs to win 51% and more to be profitable. In practice, it would be better to have 60% wins or more. With a 2:1 R:R a trader only needs 35% win rate.
Here are all of the mathematical statistics to make sure you are a profitable Forex trader:
- With a 0.5:1 R:R… You need a minimum of 67%+ wins.
- With 1:1 R:R… You need a minimum of 55%+ wins.
- With 2:1 R:R… You need a minimum of 35%+ wins.
- With 3:1 R:R… You need a minimum of 28%+ wins.
- With 4:1 R:R… You need a minimum of 21%+ wins.
- With 5:1 R:R… You need a minimum of 17%+ wins.
- With 10:1 R:R… You need a minimum of 11%+ wins.
- With 20:1 R:R… You need a minimum of 6%+ wins.
Here is a fast way of calculating if you have correct and rational control over your capital which provides positive mathematical expectancy:
Formula: Win % x Take profit size – Loss % x Stop Loss size
Win % for example 30% * take profit pips 55 – loss % for example 70% * 20p = 2.5 (positive = long-term win).
The smaller the stop loss, the better the R:R ratio when using the same target OR the better the odds of win % when using the same R:R.
Question: What Reward to Risk Ratio Do I Target?
I would like to ask you for some feedback. I think the best way to learn is by sharing the experience with each other. What kind of Reward to Risk ratio do you usually target? Please place a number and we will know it’s the ratio! For example, if you usually target a 3 reward for 1 risk, then please write down a 3. Thanks so much!
By the way, here is a great Forex educational video where you will see how powerful the concept of a 2:1 R:R really is. Make sure to take some time to read this great Forex training on the “risk to reward ratio.”
R:R using Fibs and Elliott Wave
Minimize the risk of Fib trading and decrease the potential stop loss size by splitting your trading into multiple parts. If a Forex trader decides to put their entire risk of the trade (for example 1%) on the 382 Fib, then they have no opportunity to add a trade even if the currency would retrace deeper to the 618 or even the 786 Fib.
- Splitting the trade into 2 or 3 parts allows for flexibility and psychological ease as well: a trader does not have the feeling that they will miss a trade with tying themselves down to a single entry point.
- Splitting the risk into 3 positions would mean that the trader choices to split the chosen risk of 1% into 3 parts. The risk can be evenly divided among all 3 parts (3×33%) or more weighted to one Fib level (for example 20%-30%-50%).
With a 1% risk total, this means either 3 trades with 0.33% or 3 trades with 0.2%, 0.3%, and 0.5%. This is called cost averaging. Businesses used it often: it makes their inventory cheaper. For us Forex traders, it makes the average stop-loss smaller and that is great for our R:R.
Forex traders can do the same for Fib targets. By splitting the trader with different take profit targets, they can optimize the profit average of all positions and the entire trade.
The Elliott Wave can be used to decide which Fibs and with which division % the trade is taken. For example, for a wave 2 the trader can choose to put the risk on the 500, 618 and 786 Fib with the following division of the risk: 25% on 500 fib, 35% on 618 fib, and 40% on 786 Fib. For a wave 4 the division would be skewed higher: maybe 50% on the 382 Fib, 25% on the 500 fib and 25% on the breakout.
The EW can also be used for Fib targets. A trader should aim for higher targets if a wave 3 is expected and for closer targets if a wave 5 is expected.
How To Calculate Position Sizes:
Position sizing is important because it allows the trader to adjust the size of the trade according to the market conditions. If a trader takes a fixed position size of 1 mini for example, the loss can vary widely depending on the size of the stop loss. With position sizing, that can never happen and a trader is always in control of their risk!
With position sizing, the stop loss size is not important for risk management. No matter what the stop loss size is, Forex traders always choose the risk percentage level. That said, the stop loss size is important for money management. The stop loss size is an integral part of the Reward to Risk ratio.
- Here is how any trader can calculate position sizing’:
Determine the desired risk level (risk management) à a trader determines the risk level of that particular trading strategy, trading week, trading day, market structure, and that particular trade;
- The trader needs to determine the best stop loss placement: not too close to market action, but not needlessly distant as well. Please read this article about stop losses to learn about the best placements.
- The trader needs to choose an achievable and realistic take profit target. Because we already did an article on stop losses, I was thinking of doing one on take profits next week. It depends if there is any interest. Would you like an article on taking profits?
- The R:R expectancy ratio should provide a positive mathematical expectation.
- Deposit = 5000 EUR
- Risk = 1% from Deposit = 50 EUR
- Currency pair = EUR/USD
- SL = 30p = 300 USD on a standard lot basis
- Size to open in order not to risk more than 1% = Risk/SL = 50/300 = 0.16 lots
How Much Leverage Do I Use?:
Be careful with the leverage you use. A good rule of thumb is to use for example 5:1 leverage. That way a Forex trader is not over-trading. For example, if your account balance is 5,000 USD, then your total is the capital of $5000 multiplied by your leverage of 5, which equals $25,000. A mini lot is $10,000, so that would be 2.5 minis. Use this formula to calculate how much risk you are taking: (SL times/multiplied by Leverage)/100 %. For example if the stop is 30 pips: (30 x 5) / 100 = 1,5 % of risk.
Reinvesting Trading Capital:
Regarding the trading capital, a trader has several options.
- Reinvest the profits back into the trading capital. This way the trading capital gets larger and a percentage risk of the capital is realizing a higher return in USD (same percentage risk though);
- Withdraw all profits. This way the trading capital remains the same;
- Semi-flexible approach with some withdrawals and some reinvestment.
I think that option 3 is the best money management approach. Growing your account is a great thing, but you want to withdraw some money once in a while so that you still realize that the numbers are your account are still real and not fake! Then again, withdrawing everything will take away the advantage of compounding your profit. So option 3 is the best value. You can also read about budgeting in forex for better trading.
Pro Tip – Use a Stepped Approach:
What I approach for point 3 is a step approach. This is how it goes:
- Use the same current trading capital for your risk management until you have a drawdown of x % or a profit of x% (the numbers are your choice).
- Once you hit your drawdown maximum, you will use the new trading account balance as your trading capital.
- Once you hit your profit target, you will use the new trading account balance as your trading capital.
- If you hit your profit target, you can decide the division of withdrawal and add-on % of the profit. So you could choose to withdraw 50% of your profits and add 50% of profits to your trading capital. The new trading capital balance would be your old trading capital + 50% of the profits.Also, be sure to read banker’s way of trading in the Forex market.
Hedge With Multiple Trading Accounts:
Another part of your money management strategy is that you want to make sure that you are diversified. This is also known as a hedging strategy.
- Preferably you are only investing a part of your savings into the Forex trading capital and you have a decent percentage of your savings invested in other vehicles – if possible.
- You have multiple accounts with different goals. This is to spread the risk of having your trading capital on one account. The different accounts can also be used for different strategies and purposes: one could be for long-term trading, the other for intermediate.
- Keep part of your trading capital on your account. Even though you want to trade with a certain amount of money, there is nothing wrong with keeping a part of it on the bank account. I do not think that a trader needs to put all 100% on the trading account, but make sure a margin call is not needed if you opened a trade with 1 mini. Want to learn more about mini trading? Read the ultimate guide to trading emini futures here.
Thank you for reading!
Please leave a comment below if you have any questions about Money Management in Forex!
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Money management for novice traders
Definition of money management
Money management is risk management in trading. Novice traders often don’t pay attention to this, yet it is the key to success in the financial markets. You can’t win in the long run without following the rules of money management. Technical analysis saves you money and money management prevents you from losing too much. You should bear in mind that your capital is your working tool in trading. So you need to protect it, just like you take out insurance for your car or house. Without money management, you risk razing your trading account. At the risk of surprising you, it is not a bad trading strategy that causes most traders to lose, but poor risk management and their psychology. But then, what is money management?
Money management: a safeguard against emotions
The psychological factor plays a major role in trading. Trading can be compared to gambling (like in a casino for example) by the emotions it activates in the trader, namely greed (insatiable lure of gains), stress, euphoria, depression, fear of losing, frustration and panic. All these emotions mean that traders (especially novices) can make irrational decisions and endanger their working tool, i.e. their capital. This is where money management comes in. It allows you to protect yourself against your emotions by following certain rules.
In trading, novice traders often only think about the gains they can make, but never about the losses. Losses are part of trading and you have to accept it. If you don’t accept losing, you can’t win in the financial markets. Losing trades are the daily routine of all traders. You can’t always be right. Your analysis can be the best there is, it’s the market that decides. As is said, so correctly, better to be wrong with others than right alone. Money management is used to manage loss phases and prevents you from razing your account when you are wrong.
Money management against leverage
Leverage, which determines your risk, is calculated as follows: Total amount of your positions / account balance. In other words, the larger your position sizes, the greater your risk. This does not mean that leverage is to be avoided to comply with money management rules. You simply need to take positions commensurate with the size of your capital. This is valid for all types of markets, Forex, equities, indices and commodities (with CFDs), derivatives.
Remember that leverage is accumulated on all your positions. The more positions you open, the greater your risk. However, this risk can be mitigated with diversification into different markets/products. But be warned, to be effective, diversification must be efficient. If you gamble, for example, on the increase of different shares in the CAC40, or the increase of the Euro on several currency pairs, the diversification effect is almost nil. Effectively, if the CAC40 plunges, all the shares will fall, the same goes for the Euro. This is why novice traders would be wise to ignore the effect of diversification in their risk management, because to use it well, you need to understand the correlations between different markets/products.
The leverage you can use depends on how far away your stop loss is. The further away your stop loss is, the more important it is to reduce the size of your position. It is better for your leverage, on all your positions, to be under 10. Several studies have shown that the traders who use the least leverage are those who last on the financial markets and also those who have the best performance. These traders generally use a leverage not exceeding 5, especially on Forex.
I still hear some traders bragging that they are the best because they have doubled their capital in a week. As if by chance, there is no sign of them a week later. I’ll let you guess why. It is important to understand that you can’t last in the financial markets if you use too much leverage (which induces significant risk). The goal of money management is precisely to make sure that you last. Then, it is your trading strategy that will be the sole judge of your trading results (and not your emotions or bad money management!).
If your goal is still to double your capital, go to a casino and gamble on red or black, this will lower the statistic of the number of losing traders in the financial markets.
The rules of money management
Using a stop loss
A stop loss is a protection stop that represents a level at which you feel your scenario will not occur. Stop losses are mandatory on every position! If you don’t place a stop loss, your emotions take control of you when there are unfavourable price movements and this is the beginning of the end. A single trade can be enough to ruin you (even with low leverage). Don’t believe that the price will always come back to your entry price. Some trends last several days, weeks, months or even years. In addition, a losing trade appearing permanently in your open position lines will crush your psychology. It is hard to continue to respect money management rules when they have not been respected from the beginning.
A stop loss must NEVER be moved if the price moves in the wrong direction. The stop loss level is decided before the position is taken (this is when you are most objective). Only a favourable price change should involve moving a stop loss to follow the movement and protect your gains.
Have a positive risk/return ratio
This means that your stop loss must be less distant from your entry price, in terms of points, than your price objective. All trades with a ratio below 1 should be excluded! For example, you should not take a position on the EUR/USD when buying with an objective of 1.3550 and a stop at 1.34 while the pair costs 1.35. The risk/return ratio on this trade is (1.3550-1.35) / (1.35-1.34) = 0.50 / 1 = 0.5.
A good risk/return ratio is around 2. Your expectation of gain is then twice your risk. Between 1 and 2 is tolerable but is more reserved for experienced traders. The less experience you have, the more important it is to select trades with a ratio of at least 2. This will reduce your trading opportunities but a novice usually has a lower positive trading percentage than an experienced trader (better analysis), so you need to compensate with a good ratio.
Effectively, if you open trades with a minimum ratio of 2, it means that one winning trade is enough to cover 2 losing trades.
– A study of the forex broker FXCM (conducted on its client base – FXCM is the market leader) shows that the majority of forex traders lose, not because of their analysis (50% of their clients’ trades win), but because of non-compliance with money management rules as shown in the chart below :
In red: Average losses per trade / In blue: Average profits per trade
This illustrates perfectly that the majority of traders do not use stop losses (and do not accept taking their loss) or they open positions with a risk/return ratio below 1. As a reminder, 90% of traders lose on Forex, while 50% of their trades win.
Adapt the size of your positions
For each trade, the price objective and the stop loss will be more or less distant in terms of points, according to the characteristics of the trade and the product traded. For each trade, it is therefore important to calculate the appropriate position size so as not to risk more on one trade than on another. It is important that risk is constant, this is a very important element. This risk should not exceed 2% on one trade and it is important not to risk more than 1%. If you open a lot of positions at the same time, then you could reduce your risk to 0.5% per trade maximum.
Set yourself a maximum loss threshold
There are dark days in trading when no matter how many trades you do, they all lose. This should be integrated and accepted. This does not happen often but every trader has gone through it several times. The important thing is to limit losses during these days and to be able to return without taking additional risk during the following days. This way, you will only have wasted time and not money.
It is therefore important to set yourself a maximum daily percentage loss threshold. Once this threshold is reached, you simply stop your trading day and come back the next day. To determine this, you can calculate your average performance over a winning day. Multiply this number by 2, and you get your maximum loss threshold. So, even after a dark day, you could make up your loss within 2 days. It is up to you to set this threshold but keep in mind that you should not have too large a threshold, this would give you the impression of never being able to make up for your loss. This could affect your psychology and emotions will then take over your trading.
The limits of money management
Money management is the key to successful trading but it is sometimes difficult to apply it to the letter. On Forex, for example, there is a minimum contract size of 1,000 units, or 0.01 lot (this is called a micro lot). Some brokers do not even offer this type of contract and the minimum trade amount is 10,000 units, or 0.1 lot. If your upfront investment (deposit) is too low, you are forced to leverage all your positions. This is the case on Forex, if your deposit is less than €1,000. Effectively, your leverage on one trade is calculated as follows: your position amount / your account balance.
In this case, strict money management will force you not to open a lot of positions simultaneously as that would result in the cumulative leverage (on all your positions) being too high. Another part of the FXCM broker study shows, and I quote: “It is estimated that 8/10 of losing traders with accounts under $1,000 use leverage in excess of 26:1”.
Worse, if your upfront investment is very small, the application of money management rules will penalize you in your trading results. Effectively, not being able to reduce position size, you will have to bring your stop losses closer (so as not to risk too large an amount on one trade) and you will therefore have a greater number of losing trades.
It’s not fair, but it is only from a particular upfront investment that money management rules can be correctly applied. If your upfront investment is really too low, compared to the minimum position size offered by the broker, it might be better not to make that deposit. Before opening an account with a broker, check this information.
Money management in Forex Trading
Learn more about money management strategies, techniques & tips that you can use when you trade with Forex. Avoid the risks associated with trading, and learn how to create strategies that will ensure your success in the markets.
To trade on the Forex markets is to speculate on uncertainty. Serious and professional traders should always incorporate money management strategies into their trading plan to protect their investments. Professional traders use different money management strategies along with their regular trading plan, and if you want to avoid a severe drawdown on your account, you probably will do it too. So, how do you best prepare for uncertainty?
Main article sections:
Forex Money Management
Forex money management tries to balance two things: restricting worst-case scenario losses to an acceptable level and maximising potential profits.
In other words, we are trying to avoid risking so much that you lose everything or are compelled to stop, OR trading so conservatively that most of your money is still in your wallet when you win.
Adequate Forex money management strategies allow you to keep trading through the bad stretches that will inevitably occur. There are many books written on the subject, often involving complicated mathematical analyses. However, the good news is that the best money management strategies can be simple.
As always, to succeed at trading you will need a complete trading plan that will tell you when to enter/exit, which currency pair to trade and how to manage your money.
So Forex money management is vitally important – and should be taken as a part of the complete trading plan. Below is a list of general guidelines that should be incorporated into a trading plan.
Cut losses short, let profits run
You should always use stop losses in the best possible way by allowing your profits to accumulate when you have a winning position. Traders often use profit stops for this purpose.
The fact is that trading is not about what you want to make, as profits will take care of themselves. It’s about what you don’t lose that matters
What is Money Management in Forex Trading
Trading currencies involves taking substantial risks and disparate Forex money management techniques, no matter what the system you use. Because of the free-floating currency market, currency trading without any plan has considerably more in common with gambling than investing.
That is why it is crucial to have a proper Forex business plan. That way you won’t be gambling, but instead, investing at minimal risk. We are always here to listen to you and assist you.
As a result, putting funds at risk which you cannot afford to lose should never even be considered a professional Forex trading behaviour. This includes money needed for crucial housing expenses such as your mortgage or rent payment, or the weekly costs that are necessary for you or your family’s sustenance.
In general, traders perform better by only trading forex with funds known as risk capital.
That amount of money has been predetermined for trading because it is expendable and therefore not needed for the essentials of living.
Currency pairs tend to move in correlation with one another more than other asset types such as stocks. You need to understand the Intermarket connection in order to make better trades. That is, they’re strongly correlated either positively or negatively. If you trade the majors, all of your positions are likely to be correlated with one another as most significant pairs are connected to USD. Remember, Forex money management rules need a complete understanding of Intermarket correlation.
Checking both the ‘historical’ and ‘now moment’ correlation is important. If you use MetaTrader, then MetaTrader 4’s Supreme edition is the right tool for you.
It will make decisions based on your overall account exposure. If you allow high exposure on correlated pairs, your account balance will be heavily affected by the movements of just one or two of them.
Compound Your Account
Compounding describes how numbers, or money, can grow. Compounding is the exponential growth of a sum of money by continuously reinvesting all profits without any withdrawals, so although the profit percentage remains the same, the original amount of money might grow at a rapid rate.
With the power of compounding, in the long run, you will be able to grow your account by a considerable amount! This could be a good Forex money management plan for you!
Be careful with emotions
However, beware of human emotions. As the stakes get higher, you will suffer more from emotions as you realise you are working with much bigger stakes. If you notice that this is happening it means it is time for a “wake up call” and time to step back into reality.
Professional traders recognise this, and they will not let their emotions drown their profits. By applying this advice, and trading money management, you’ll be ahead of 95% of the crowd, and you should be able to make consistent profits.
Don’t forget that the Forex Holy Grail lies hidden inside you. Hone your money management skills with our free demo account.
Stay tuned! Follow the updates in our Education section.
This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.
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