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Money management is the most important aspect of trading. Having a sound money management system will make a huge difference in your profits. It will help improve your performance and minimize your losses.
Money management is what can separate you from going broke to becoming a successful trader. Many traders do not realize there is not always a reward in the market but there is ALWAYS risk. Although profits cannot be predicted, the only factor you can control is risk.
Money management basically deals with 3 elements:
- Choosing the size of your position (position sizing is the calculation of how many lots you should hold in a position).
- Damage control (this is the amount to risk in each trade (in USD).
- Setting your stop loss in pips away from your entry level.
Maximum Drawdown
The term drawdown means that your capital is reduced due to losing trades. The more you lose in your account, the harder it is to make it back. Therefore you should only risk a small percentage of your account in each trade, with a maximum of 3%.
Drawdowns on your account are part of trading but if you establish a trading plan then it will enable you to survive these losses and not wipe out your account.
To calculate the drawdown you would usually take the difference between the highest equity value in your account at one time minus the lowest. It is then usually represented as a percentage of your trading account.
Below you can see an example that shows what percentage you would have to make to break even if you were to lose a certain percentage of your account.
| Loss of capital | % Required to get back to breaking even |
|---|---|
| 5% | 5.26% |
| 10% | 11.11% |
| 15% | 17.65% |
| 20% | 25% |
| 25% | 33% |
| 30% | 43% |
| 40% | 67% |
| 50% | 100% |
| 60% | 150% |
| 70% | 233% |
| 80% | 400% |
| 90% | 900% |
You can see that the more you lose, the harder it is to make it back to your original account size. This is the reason that you should do everything you can to protect your account. Therefore, it is best that you only risk a small percentage of your account in each trade so that you can survive your losing streaks and also to avoid a large drawdown in your account.
Stop Loss
Many people trade without any system that manages their risk. They trade without using a stop loss. A famous professional stock trader by the name of Alexander Elder described trading as being like a high-wire act. In his book entitled Trading for a Living, Elder said You may walk the wire a hundred times without a safety net but the first fall can kill you.
However, you cannot afford to take that chance. You can have a system that is 99% accurate and lose money. You can also have a system that is 1% accurate and make money. Which one do you choose?
How Much to Risk and When to Stop Trading
The key element of money management is not to be greedy! Before you start trading you have to establish how much you are willing to risk losing in one year, and if you do lose money you have to know when to stop trading so you do not lose more than planned.
Below is an example that shows when you should stop trading based on how much you lose and in what time period.
| Amount to Risk in 1 Year | $9,000 |
| Monthly Stop Loss | Lose $3,000/month |
| Daily Stop Loss | Lose $1,000/day |
| Stop Loss per trade | Lose $300/trade |
| If you lose $9,000 during the year, stop trading for the rest of the year If you lose $3,000 during the month, stop trading for the rest of the month If you lose $1,000 during the day stop trading for the rest of the day Set your Stop loss to $300 per trade |
|
Risk-Reward Ratio
Once you have established how much of your capital to risk, it is also good money management to have a reasonable risk to reward ratio per trade. The risk to reward ratio shows how much money you are risking versus the potential reward (or profit) on a trade. While this may seem simplistic, many traders neglect taking this step and often find that they end up with large losses.
A good risk to reward ratio, especially for new traders is 1:3. Any number below 1:2 is too risky. It is best not to enter a trade in which the risk reward ratio is 1:1 or the risk outweighs the reward. There is very little room for smaller price movements and the amount of risk will increase.
Have a look at few examples of risk to reward ratio:
- If the risk is $200 and the reward is $400, then the risk-reward ratio is 1:2 (calculated by 200:400)
- If the risk is $500 and the reward it $1,500, then the risk-reward ratio is 1:3 (500:1500)
- If the risk is $1,000 and the reward is $500, then the risk-reward ratio is 2:1 (or 1000:500)
Now set’s assume you are trading EURUSD. You enter at a price of $1.3000 and you want make a profit of 45 pips so you set your exit level (profit target) at $1.3045. You set your stop loss at $1.2985. This is 15 pips below your entry level. This means your risk to reward ratio is 1:3. You are risking 15 pips for a chance to gain 45 pips.
Position Sizing (Number of Lots)
Choosing the right number of lots will improve your risk-return ratio. In forex trading, position sizing is particularly important since leverage is involved. If you trade too many lots, a string of losses could force you to stop trading. On the other hand, if your position is too small, much of your account equity will sit idle, which will hurt your performance. Finding the right balance is the key to risk management.
Calculating the Size of Your Position
- First set the amount you want to risk per trade e.g. USD 1,000.
- Find the entry level (price). Suppose your system gives you a signal to Buy EURUSD at 1.2950.
- Determine your stop loss level. This will usually be a few pips below the support level e.g. 1.2900.
- Use this to calculate the number of pips between the entry and exit levels of your trade. 1.2950 – 1.2900 = 0.0050.
- The question you have to ask now is: If you put your stop loss 50 pips away how much do you risk for every lot in EURUSD? Since 1 lot is 100,000 base units, 100,000 * 0.0050 = USD 500.
- Finally divide your stop loss amount ($1,000) with this number to give you the amount to trade 1,000 / 500 = 2 lots.
Calculating the Amount to Trade
| Stop Loss Per Trade | $1,000 |
| Entry Level | $1.2950 |
| Stop Loss level | $1.2900 |
| Stop Loss in pips | 1.2950 – 1.2900 = 0.0050 |
| Amount to risk per lot | 100,000 * 0.0050 = $500 |
| Amount to Trade | $1,000 / $ 500 = 2 lots |
Martingale or Anti-Martingale
Different day traders have developed many different ways to manage their money. Some base their trading strategy on different statistical probability theories, and some base it on strategies used in casino gambling. Such are the Martingale and anti-Martingale strategies.
In the Martingale method, you decrease the amount of risk after you win a trade and you increase the amount after a loss. The simplest of Martingale strategies was designed for a game in which the gambler wins his stake if a coin comes up heads and loses it if the coin comes up tails. The strategy had the gambler double his bet after every loss, so the first win would recover all previous losses plus win a profit equal to the original stake. Since a gambler with infinite wealth would eventually flip heads, the Martingale betting strategy was seen as a sure thing by those who advocated it. Of course none of the gamblers in fact possessed infinite wealth and the exponential growth of bets would eventually bankrupt those who chose to use the Martingale. Stay away from Martingale strategies!
The alternative method is known as the anti-Martingale method. You increase the number of lots as your profits increase and you decrease the number of lots as your equity drops during a drawdown. When you make a profit it means that the market is trending so increase the amount of your trades to follow the trend.
