Risk Disclosure

"Forex trading can involve the risk of loss beyond your initial deposit. It is not suitable for all investors and you should make sure you understand the risks involved; seeking independent advice if necessary"

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Sunday, November 25, 2007

Money Management

Money Management

Many traders think successful trading is all about entering and exiting the market. Managing your money is important to understand and master before you trade real money. Ironically, this is one of the most overlooked areas in trading. The chances are, you will fail as a trader, regardless of how good your other trading skills are unless you learn the the art of money management.

Traders are all too eager to enter the market without regard for their total account size. Their strategy is based on how much draw down they can stomach or how long their nerves will last on each trade. Statistics reveal that only between 5 and 10% of the millions of traders out there actually wind up making any money. It is at this point in your trading career that you can decide which side you are going to join, the winners or the losers.

Trading without regard for money management is called "GAMBLING". Either consciously or subconsciously most traders start their career visualising "The Big One"the trade of all trades that will make them millions, allowing them to retire and live a fairy-tale life forever after. If you are hoping for a "Jackpot" then rather go to the casino.

The cold truth is that instead of the the "Big Win" most traders fall victim to the "Big Loss" and get knocked right out of the business. Trading is for serious investors looking for long term sustainable profits. Good money management rules will not only prevent heavy losses, they will help to make trading profitable in the long run.

It is my belief that this is where most traders fail. If you can succeed with managing your funds and be a mediocre trader you can succeed at this business. Don't just pay lip service to money management put it into practice. Money Management can seem like a burdensome task that forces you to take necessary losses, and few of us like taking losses. Taking losses though is crucial to long-term trading success and should be considered a by product of trading rather than failure.

First examine your motivation for deciding to become a trader.
Are you planning a full time trading career? or are you doing it to supplement your income? or build sufficient capital to become a full time trader some time in the future.

If you are planning on making a living solely out of trading then the first thing you need is adequate capital. If your starting capital is insufficient then you are probably doomed to fail before you start. Inadequate funding will cause you to take unnecessary risks, because you will be under pressure to meet your financial commitments at the end of the month. It is impossible to arbitrarily prescribe a sum that is sufficient as each person has a different lifestyle and income needs.

Trading is a business and as such needs a business plan. Just because your trading business is a part time venture it does not mean you don't need a business plan.

Start off by writing down your reasons for trading. Calculate how much you would like to earn from this business and over what period of time. Write down your money management rules and trading strategy. Commit your plan to memory and imagine yourself being a successful trader and achieving your trading goals.

Trading books, seminars and trading courses are littered with stories of traders losing one, two or even 5 years of profits in one trade gone terribly wrong. The runaway loss is probably due to sloppy money management and lack of discipline. Do not become the victim of an unmanageable trade.

What is proper money management?
Money management in Forex is as flexible and varied as the market itself, just surf the net and you will find rules that suggest anything from "don't risk more than 10%, 5%, or 1% of your capital on a trade. Some strategies even suggest trading without stop losses. Hopefully this next section will help you understand the dangers of trading without an equity management plan as well as give you some useful information on how to control your risk.

As a fund manager I only risk 1% of capital per trade. This takes out some of the emotion of trading because once in the market I can only lose a very small proportion of my capital. Even If I had to lose 20 trades in a row I would still have 80% of my capital in tact and would not be out of the game.

That does not mean just arbitrarily risking 1% every time I see a good set up. I use a combination of an equity stop (1%) and a chart stop (swing High or Swing low) to determine if the trade falls within my money management plan or not. If the risk is too large then I give it a miss. There will always be other trading opportunities.

The next step is to determine the potential reward on the trade through technical analysis. If the potential reward is smaller than the risk then again its a no trade. Rather look for trades where the potential rewards are 1.5 to 3 times greater than the risk.

This money management plan allows control of the risk on each trade regardless of margin requirements or leverage. It might not find agreement with all traders or even suit all traders, but it is a plan and it works very well for me.

Because of the flexibility and diversity of the Forex market, there are many different trading styles and strategies that might require different money management approaches. What is certain though is that we have to have a plan, that should limit risk, utilise stop losses, and offer high risk reward ratios.

Assuming again we had $5000 capital to do the above trade. Our risk is 1% of $5000 =$50. The stop loss is 25 pips which means we can enter the short trade with 2 lots on a mini account. The profit potential on the trade is almost 130 pips which is 5 times our risk. The profit target has been determined by the previous low in the market at 1.0921 which has been trending short for some time.

Obviously there is no guarantee that price will go down to that low, but the risk is certainly worth the potential reward. As we can see price failed to achieve that low, but it did rally down almost 100 pips before reversing. The eventual reward was almost 4 times our risk.

We risked $50 on the trade which is 1% of our capital and could easily have closed out the trade when we were up 75 pips for $150 profit which is 3% of our capital. had the trade gone against us our loss would only have been $50.

(For this USDCHF trade I have rounded the numbers to $1 per lot for the sake of an easy explanation. The actual risk reward ratio would have been slightly less as the USDCHF pairing is slightly less than $1 per mini lot)

What happens if we don't have a money management plan?
Lets say you have a 5000 $ account and you lose 2500 $. That is 50% of your capital.
In order to recover your capital you will have to double your remaining capital of $2500. In other words you have to make 100% profit to get back to where you were. This is called draw down and for this example we have had a 50 % draw down.

The point is that it is a lot easier to lose your money than it is to make money. If you have 4 or 5 or even 10 losses in a row where would that leave you? Even a trading system that wins 80% of the time can still go wrong. This means you should win 80 out of 100 trades. Which 80 are you going to win the first 80% or the last 80? 80% does not necessarily mean you will win 8 out of 10 trades. Even if you win the last 80 trades you will still have a 80% win ratio.

The question is will your capital survive 20 losses in a row. Regardless of what system you use or how successful a trader you are sooner or later you are going to have a loosing streak. Losing trades are a by product of our business, but its how we manage our losses that decide whether we stay in the game or not.

What happens if we hit the dreaded loosing streak?
Lets assume we have $5000 and do 1 loosing trade a day for the next 20 days.

TradeCapital10% RiskBalance2 % RiskBalance
439288 166233

Maybe the above is an extreme example with 20 losses in a row, but it clearly illustrates the difference between a high and low risk. With a 10% risk per trade we lose 88% of our capital compared to 33% on a low risk. Obviously, nobody wants to lose 20 trades in a row, but even if only 5 consecutive losses occurred, the difference between risking 2% and 10%. is enormous. With a 2% risk we still have $3338 after 20 losses compared to $2952 after only 5 losses trading a 10% risk.

The point is, regardless of how good your trading system is your risk management should allow for the worst case scenario because sooner or later there will be a loosing streak even if it is only 5 or 6 consecutive trades.

The next chart will illustrate what percentage you need to make after a losing streak just to get back to break even.

Loss %Profit% for B/E

An 88% loss therefore would require returns of almost 900% just to get back to break even compared to the 33% loss requiring a 60% return on remaining capital to get back to break even. It is clear from the above figures that the bigger the loss the more difficult it is to recover the capital and return to break even.

The next table will illustrate the importance of doing trades with a risk to reward ratio of 1.5 to 3 times the loss potential.

TradeLoss1.5X Risk3X Risk

The above table shows that even if we only win 50% of our trades we can still make money provided our gains are more than our losses.


  • Losses are a reality and will happen to you at some point.
  • The less you risk per trade, the less your maximum drawdown will be.
  • The more you lose in your account, the harder it Will be to get it back to break even.
  • Risk only a small percentage of your account. The smaller the better, 3% or less is recommended.
  • It is preferable to trade only high risk to reward ratio. The higher the ratio, the less you have to be right.
  • Limit your risk factor.
  • Don't trade without stop loss protection.
  • Be swift to cut losing trades, never allow them to become runaway trades.
  • Never allow your emotions dictate your actions.
  • Have a trading plan and stick to the plan.
  • Ensure you are adequately capitalised to meet your personal goals.
  • Practice makes habit, learn good money management habits and practice them until they become habits.

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