Money management is probably the most important and most overlooked part of building a successful career in trading. Combined with a successful market strategy, it will enable the trader to take out the emotional and psychological aspects and to make money over the long term. I often say that a successful trader is actually a risk manager, and although we all think it is about entering a trade, managing it is far more important. However, you must have confidence in your trading system otherwise you will fail.
Having a trading system that you believe in and a set of money management rules that meet your goals removes human emotion and stress from trading, and makes sure that the odds are firmly staked in your favour.
The most important reason you should have a proper money management technique is to ensure that you can remain in the markets long enough to become profitable, because when the money is gone the game is over. A good money management system can be applied to any trading method and answers a question we often hear at Global Forex Pros - what size position should one take or, how much leverage should be used?
Most people spend their time and money focusing on the trading method and overlook the psychology of trading itself. This can be the hardest part to control, not just for new traders. But with correct money management rules in place we can distance human emotion and will still have capital available for future trading opportunities. With that in mind, do not rush into trades - there I can assure you it won't take long before another shows up.
You may be surprised to read that more than 20 per cent of traders do not use any form of Risk Management at all (i.e.: no stop losses), and most have no particular trading. Five years ago, more than 80% of new retail traders would get wiped out within the first 9 months of trading. So how do you protect your capital and still make money?
First, it is essential first to understand exactly how you express risk in trading and if the level of risk you are using is realistic in terms of potential success.
Over the years I have worked with many traders, both successful and not, and it has become quite clear where mistakes are made and who makes them. If you were to ask 100 different traders with varying experience you would get 3 different answers as to how they allocate risk for each trade.
1) Pip risk. Many inexperienced traders use this very simple method which is not guaranteed as optimised and could result in failure. They simply say they will risk a set number of pips paying no attention to levels or market volatility.
2) Dollar or monetary risk. This is a method where the trader simply allocates how much he is prepared to lose and make on each trade. This is not a good idea and similar to the above will result in not only in losses but also trades would close too soon.
3) Percentage risk of capital account. This can be either fixed or variable and as I will show you later, this is the method we believe will enable you to maximise your profits over time.
Most people probably use pip values as their method of expressing risk, but as we said this is not an optimised method as it doesn't take account of market volatility. But what do we mean by volatility? It is simply the amount of uncertainty or RISK about the size of change in a currencies value. Higher volatility for a currency means that the potential range of prices for the currency pair is spread out over a large range of values. This means that the price of the currency can dramatically change over a short period of time in either direction. Obviously volatility changes throughout the day, depending on news and economic releases and even the actual time, especially as we approach major numbers such as Nonfarm Payrolls or Fed rates decisions.
If we look at the chart below of this month's Nonfarm payrolls, we can see what a tight range we traded in the European morning with the uncertainty of the number and expectation of a sharp move in either direction or the spike (increased volatility) following the data release. It is essential to let the market dictate the volatility, and running positions into these high volatile events not only will risk a set amount of pips, it may result in increased loses as the market gaps through prices. Also, if you use a fixed pips method then you are not observing and understanding the market conditions. I know people who risk 10 pips to make 20 pips working on the fact that they can be right once for every 2 losses to break even, but this method will result in missing major moves.
Source: Bloomberg Charts
Losses are part of trading, and you must be prepared to accept them. By using the above method you are not learning anything about the market’s condition and underlying direction. Think of a stop as the cost you must pay for market information through price. Also, if you use a fixed pips loss basis then the risk on your capital base is variable, as pips have a different value depending on the currency pair, e.g. 1 pip in EUR/GBP is more expensive than 1 pip in EUR/CHF and we should consider this when building a successful money management system.
Some people also use a fixed number of lots per trade, for example 1 lot per trade, but this is also ineffective, as it not only ignores the size of the base currency (and therefore the cost of the pips) but it also means that you are not optimising the profit potential on the risk taken.
A lot of people express the level of risk they are prepared to take through a dollar or monetary value - $100 per trade for example. I have even known traders at banks to say once I have lost $20,000, close my positions - only for the market to turn around in what would have been their favour. It may be easier to accept the fact that you have risked a set amount, but it still has to be converted into the number of pips prepared to risk to be able to place the stop. Using this fixed monetary method may in fact place your stop just above a major support. It also needs to be related to the size of position and the larger the position, the closer the stop - as well as ignoring current volatility in the market.
We are therefore left with using a fixed percentage risk of our capital base. Personally I usually 1% per trade or up to 2% depending on my confidence in the trade, or if I have added to a winning trade. It is essential that you choose a level that you are comfortable with and that also matches you trading expectations. If you want to make 10k a month and have 10k in your account that's 100 per cent return in your 1st. month which you will have to be very lucky with, and the level of leverage and risk management will ultimately end in wiping out your entire capital.
The number one job as traders is to protect our capital base, enabling us to look for the best trading opportunities, and risking a fixed low percent on each trade enables us to make mistakes and to learn from them whilst staying the markets.
When using a fixed percentage of capital we look at the market conditions, volatility and support/resistance levels - the market is telling us how many pips we can risk on the trade. We can then calculate the dollar (monetary) risk and therefore the lot size.
For example: Let us assume we have a capital base of $100,000. Looking at the chart below, we believe that in the short term the EUR/USD will turn lower and we want to sell on a simple crossover in the moving averages. This means that if we are wrong, we will lose 58 pips. If we are prepared to risk 1 % ($1000) then 58 pips means we can take a position of 170,000 Euros, Thus making a profit of 142 pips or $,2414 which is 2.4% of our capital base.
Source: Bloomberg Charts
This is a very simple and effective money management technique which adjusts to the size of your capital. Dollar or monetary risk will grow as your capital does, and once your trading is successful and grows as in the above - for example to $120,000 - you can now risk $1200 per trade. If a few losing trades take the capital base down to $95,000 then the ticket size will be adjusted accordingly to risk $950.
In our next article we will show you the relationship between trading performance and a few simple money management techniques.
