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Money Management

 

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Money Management

In our experience, if you were to ask professional traders what contributes to the successful profitable trading in any financial market, most of the time you would hear that 50 percent depends on your abilities to determine when and what to trade with and another 50 percent depends on your money management skills. Some of the traders would disagree with such approach to trading, they would say that we attribute too much weight to money management. For example, Bruce Babcock thinks that 1/3 of the success is your trading system, 1/3 is money management and another 1/3 is the trader's ability to strictly follow developed trading rules. Does not matter which side you would agree with, money management plays too big of a role to be passed by or just paid lip service to, as many beginning traders do.

Money Management is a science that allows you to:

  1. Understand how and when to use different money management techniques/approaches that seek to :

-         maximize your profits,

-         limit your risks and losses

  1. Realize connections between different money management approaches and different statistical peculiarities of some particular trading system:

-         inconstancy of the results,

-         loss or profit probability

-         correlation between profitable and unprofitable trades.

Now let us define money management in a way that would be clear to all traders. Money management - is a tool that allows you to make educated decisions on what part of your trading account should be risked on any particular trade.

If we forget for a second about psychological aspects then 50 percent of our trading is attributed to entering the market and another half is how much risk we can afford. From first sight these two trading inputs are totally independent from each other but when we take a closer look we will see that they are interconnected.

Traders can receive entry signals and then decide how much capital they would like to risk on this particular trade - 2 or 4 lots, for example. Nevertheless, in absolute terms a trade is either a win (profit) or loss and there is no difference how many lots the trader was risking. In this case two trading inputs are not connected.

On the other hand, these two trading inputs can be closely connected to each other. Let us examine a situation where a trader has a stop loss set to $300, although $500 is more viable since it is located under some major support level. But our trader has to set his stop loss at $300 since his capital is limited. In this case, correct money management technique can affect whether this trade will bring profits or losses.

Even when your money management approach does not affect your trading system, it will always affect the size of your trading account. Each trade is a risk to win or lose some amount of money. Therefore, each decision to entry the market in some way affects your account size. The money management approach that you will choose to use will determine on what degree your trading decisions will affect your account size. Those decisions are based on certain needs of a trader. For example, some traders would want to maximize their profits and some, would want to minimize their losses. Most of us are somewhere in between.

Despite the fact that money management accounts for 50% of a trade development, most traders spend 3 times more efforts on studying about different trading systems rather than reading at least basic principles of money management. Partially this is because there is not so many good books and articles available on money management. Nevertheless, the main problem is with trader's attitude. Although it is obvious that money management greatly affects the size of trading accounts, not too many traders spend their time and efforts on studying this subject.  Instead of that, most traders concentrate on choosing right timing to enter the market to maximize their profits.

It is easy to get stuck in this trap. First of all, commonly used software to develop trading systems do not allow much room for integrating money management techniques. In this situation traders are deprived from real tools for evaluating different money management systems. Secondly, necessary calculations are time consuming. For example, let's say that a trader wants to know how much total profit he would make every time he risks precisely 10% of his total account size on each trade. This simple problem needs many calculations. These and other situations leave very limited number of way to evaluate money management techniques.

Nevertheless it should not stop you from deploying suitable money management system and try to evaluate how it will improve your trading results. If you spent couple months developing and evaluating your trading system, you should dedicate at least half or the same amount of time to deploying and evaluating chosen money management system.

Basic Money Management Techniques 

There are many money management techniques but we will cover only those that we think are the most frequently used by traders and those that have potential to contribute to your successful trading. Below we will briefly define seven of them and later will cover more in depth some of the listed techniques.

Lack of money management - this technique is actually used by many traders or maybe it is better to say no money management is used at all. With this method traders enter the market with 1 lot every time there is a signal generated by their system. Of course, there are pros and cons for this technique that we will look at a bit later.

Multiple Contracts/Lots/Trades - this technique is similar to the first one in our list but it differs by the number of trades/lots used.  We will look at some specifics of this method later in this chapter.

Fixed risk capital - when using this technique, traders determine what amount of their capital they will risk after each signal. For example, they can use an amount up to $2000 for each trading signal.

Fixed percentage of risk capital - when using this method, traders determine which percentage of available capital they are ready to risk on each particular trade. For example, they can use 3% of total capital to risk on each trade.

Pyramid building - also known as Martingale system. When using this technique, traders determine how much they will risk on a particular trader relaying on the previous trades. For example, if there was one loosing trade next trade size will be doubled to offset previous loss and so on.

Price crossings - when using this method, traders take two moving averages (for example 3 and 8) of losses and profits. When shorter moving average is bigger that the longer moving average, this means that the system works better than in the past. Based on this information, traders can open new positions. If shorter moving average is located lower than longer moving average then there should not be any trades.

Optimal f - another trading technique that is very powerful when used correctly. Many traders know about this technique but it has some hidden peculiarities that need to be watched for. 

RECOMMENDED READING

To get a thorough understanding of proper money management techniques, we highly recommend reading the book titled The Trading Game: Playing by the Number to Make Millions by Ryan Jones*. The money management strategies outlined in this book can be automatically implemented (100% hands-free)  in ProSignal's Automated Forex Trading Platform. This book will really help you understand the power behind the strategies and how they work.

Disclaimer: The Views and opinions represented in the provided website links and resources are not controlled by the Referring Broker or the FCM. Further, the Referring Broker and the FCM are not responsible for their availability, content, or delivery of services.

Now let's take a look at some of the above mentioned techniques more in depth.

Lack of Money Management 

This is the simplest and commonly used technique. This method is mainly used by small investors. Using this method traders buy or sell only one lot/contract. They do not account for such factors as risk size for each trade, amount of available capital, past performance and so on. Therefore, this type of money management is used by many software packages and trading systems.

Initial capital is the most important factor that traders need to pay attention to if they decided to use this money management technique. Depending on the amount of the initial capital, this method can become either very risky/dangerous or very conservative way to manage the capital. The more capital you have the better it is. When there is very small amount of capital available then with each trade you will be risking most of your account. Many small accounts will not withstand 2 or 3 consecutive losses. As a result, small size of your account will increase the possibility of loosing your whole capital using this technique.

If the account size is big enough, then this method becomes very attractive. Nevertheless, other money management techniques could bring you more profits with the same amount of invested capital. This is because "lack of money management" technique does not give the trader any tools that will help to regulate the risk or tools to classify profits and losses.

Multiple Contracts/Lots/Trades

This form of money management is almost identical to the "lack of money management" technique that we already covered. The only difference is that with this method a trader will use multiple lots for any particular signal. You have to keep in mind that doubling or tripling the amount of money your are ready to risk on a particular trade could affect your account no in a linear way, it can increase the possibility of getting a margin call.

One of the main problems with this technique is that it increases the size of one-time losses. The good news is that with the increase in number of lots the profit will be increasing too. If you want to increase your profits using this method, please keep in mind that your losses will increase to and try to use very accurate trading system to reduce the number of losses.

The main problem with this method is that it is hard to forecast how the losses that you will get by using this system will affect your trading in general.  If you want to become a professional trader, first thing that you need to think about is how to minimize your losses. Most of the times, especially when we are talking about institutional investors, it is more important to minimize your losses than to maximize your profits.

Fixed Risk Money Management

This is another frequently used money management system that traders use. For example, if the trader starts trading with $20,000 capital he/she can decide to risk on each trade no more than $1000.  This way the trader will number of lots that will come close to the preset $1000. If, for example, one lot equals to $500 then the trader might trade 2 lots.  If one lot equals $800, then the trader would trade only 1 lot, since 2 lots would exceed his fixed risk capital = $1000.

This methods allows some traders to effectively use their systems that are based on percentage correlation between winning and loosing trades. In the example above, the trader can be sure that his system can have at least 20 attempts to show its validity. This aspect is especially important for some systems that are trend following and which usually have only 30% of winning trades. Moreover, by having predetermined fixed risk capital and knowing the percentage ratio between winning and loosing trades, the trader can calculate in advance what maximum drawdown of his account he should expect.

For example, if the trader has a system that gives winning trades in 50% of the cases, there would be nothing unusual if this system gives 3-5 losses in a row.  If the trader risks $1000 per each trade then in the most unfavorable scenario he would only loose $3000-$5000.  More conservative traders can go even further and by considering the fact that the system gives 50/50 percent results, and getting 7 consecutive losses with probability of 1% set their maximum draw down level at $7000. 

Fixed risk capital method is great way to filter your system. It can help you to improve your trading and profitability. One thing that you have to keep in mind is that with this method you need to know your system very well and especially what is the percentage ratio between loosing and winning trades. Otherwise, you run a risk of setting to high or to low fixed risk capital amount and ending up either not getting all possible profits or even loosing your whole capital.

Fixed Percentage of Risk Capital

The main weakness of the above described method is that it is not possible to change risk size when the capital is growing or diminishing. This could be corrected by using the fixed percentage from total risk capital on each trade. This system allows the trader to increase risk amount on each trade when the total account size is increasing and decrease the risk amount on each trade when the total account size is decreasing.

The method is based on allocating certain percentage of total account size to risk on each trade. For example, the trader might decide that he wants to risk every time he trades new signal only 10% of his total account size. After this decision is made, every time before the traders places a new trade, he first  calculates the 10% of his total account size and risks only this amount on that particular trade. If the account size is $20,000 then he would risk on each particular trade only $2000. For the next trading signal, the trader will have to recalculate the percentage value, since the account size most probably will change.

This method aims to improve the results by including already gained profits or losses. Other methods require changes to be made in accordance with the growth of the account; in this case it is happening automatically.

Martingale Money Management System

A money management system of investing in which the dollar values of investments continually increase after losses, or the position size increases with lowering portfolio size.

This is a very risky method of investing. The main idea behind the Martingale system is that statistically you cannot lose all the time, and therefore you should increase the amount allocated in investments--even if they are declining in value--in anticipation of a future increase.

The Martingale system is commonly compared to betting in a casino. When a gambler using this method loses, he or she doubles his or her bet. By repeatedly doubling the bet when he or she loses, the gambler will (in theory) eventually even out with a win. Of course, this is assuming the gambler has an unlimited supply of money to bet with.

To use this system in Forex trading you would need to deploy highly accurate trading system. Moreover, you will need to be able to calculate your Reward/Risk Ratio and know your accuracy rate. The reward/risk ratio or RRR is the profit you expect divided by the losses you expect on any trade in question. In other words, how much you are risking and how much you expect to make. Accuracy is simply the percentage of trades you get correct.

Your RRR must be consistent with your accuracy rate for a particular system. Keep in mind that reward/risk ratio and accuracy are usually inversely correlated. The higher the RRR the lower the accuracy rate and vice versa.

For example, if you are using some scalping system that only holds positions for a couple pips and you are trying to achieve high accuracy rate, you do not really need high RRR to have positive expectancy. If we take an example where your system has 90% accuracy rate then all you need is .5 RRR. Trading just 10 trades will give us 9 winning trades and 1 loss. The average loss will be 2, so net result would be 9 -2 =7. When adding advanced risk management concepts like dollar cost averaging, pyramiding, and a Martingale principle, you can enhance your expectancy further to create some really nice results.

Before even starting to use the Martingale system you need to remember one rule, do not exceed 2% - 5% risk on any trade. This means that before placing any trades your have to determine position size based on the rule above.

A high accuracy system will be correct 8-9 times out of 10. The only drawback to this is that your losses will be larger than your winners. So once you hit a loss, it will take a big bite out of your winners. What if there was a way to recoup that loss very quickly? The Martingale strategy can help you do just that.

First you must understand that it is not a good idea to trade near the upper limit determined by the 2%-5% rule when using a Martingale strategy. So if the largest position you can take is 10 standard lots, when using a Martingale strategy we would recommend you start with 2-3 mini lots.

Since it is statistically fairly unlikely that you will have a great deal of losing trades in a row in a 90% accurate system, you can play with the position size to put the odds in your favor.

Let's say that you have an RRR of .5; you will loose $2 for every $1 that you win.

As you accumulate your winning trades, keep the same position size (let's say 2 mini lots). Once you hit your first loss, you can double the position on the very next trade because since the system has high accuracy, the chances of 2 losses in a row are not very high. If the next trade does turn out to be a loser, you double the position again. You can double up to your maximum position size calculated by the 2% rule. Once you hit that size you should just keep that size as you trade until you hit your next winner. However, because you are starting out with such a small portion of your account, this is not likely to happen.

Using the Martingale approach can be very beneficial in increasing performance of high probability strategies. This strategy must be used in conjunction with the 2% - 5% rule and may be used in conjunction with other risk management principles. Nevertheless, you have to keep in mind that this system is very risky and dangerous if misused and if certain rules described above are not followed.

Price Crossings and Optimal F

These two methods are very complicated and are hard to use for beginners. They involve a lot of work and calculations so we do not recommend using them before you get a firm grip on basic Forex trading concepts and money management techniques. Optimal F is thoroughly explained in the book titled The Trading Game: Playing by the Number to Make Millions by Ryan Jones*

Disclaimer: The Views and opinions represented in the provided website links and resources are not controlled by the Referring Broker or the FCM. Further, the Referring Broker and the FCM are not responsible for their availability, content, or delivery of services.

In conclusion, any money management technique can greatly improve your performance if used correctly and in conjunction with the right trading system. Nevertheless, if your system is erroneous at its core, no money management technique will help you; or opposite it might even worsen your results. Our advice is to start using money management technique only after you have tested your trading system for several months on your demo account and know how it performs in certain market conditions very well so you could apply the most effective money management method to it.

Disclaimer: Please keep in mind that no "safe" trading system has ever been devised, and no one can guarantee profits or freedom from loss

 

Topics Related to Money Management:

  

Home: Fully Automated Forex Trading Systems with Automated Trade Execution on 300+ Forex Trading Strategies

Home 2: Auto-Trading Performance

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Part 3: Forex Charts

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Part 5: Technical Analysis

Part 6: Technical Indicators

Part 7: Fibonacci Analysis

Part 8: Elliot Wave Theory

Part 9: Candlestick Chart Analysis

Part 10: Money Management

Part 11: Trading Psychology

 

 

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