Money Management for Currency Traders: An Introduction
Some might say that trading is a form of gambling. Now, that can mean one of two things to you.
Either you’re a gambler in the sense of the typical emotionally-driven adrenaline-seeking sucker, whose every thought pattern and decision was already predicted by the design of the casino (and the loss of your money is almost guaranteed before you even choose a table or slot machine)… Or you’re the kind of professional who might get kicked out of the casino and banned for life, for being one of the select few who are actually able to make money — and keep it.
In the currency trading world (and futures, options, and stocks for that matter), the suckers are already a dime a dozen. Or make that a mini-account-a-dozen, maybe.
If you’re serious about trading to make money, then it’s time to stack the odds in your favor. Always keep in mind that what you’re naturally inclined to do… probably will cause you to lose money in the long run. So fight your natural (and predictable) instincts and learn to keep your profits.
The first step is to learn to manage your account balance like a pro.
TRADE FOR SURVIVAL
What good is making a thousand tonight if your methods are more likely to cause you to lose two thousand tomorrow night? If you’re looking for a lottery ticket, they’ve got cheaper ones for you at the convenience store. If you want to build your equity and grow your wealth, then learn to trade for the survival of your account.
Risk between 2% to 5% per trade, at the very most. Some have gotten away with more, but their risk of ruin is also a lot higher when that eventual dry spell comes along. No one is perfect, not even the hedge fund managers on Wall Street, so don’t assume you can trade with a perfect track record. Prepare for the worst so you can survive the storms to come.
The drawback, of course, is that the less you risk, the less you can potentially make at once. I realize that most beginners are probably saying to me, “that’s easy for you to say! If I had an account with a balance like yours, I’d be happy risking 2% too!”
Believe it or not, I remember what it was like starting with a micro account with a balance of less than $1000 USD. The thing you need to drill into your head, though, is that I never made that work for me either until I accepted that I needed to treat the first $500 as if it was a huge account already.
Think in percentages, not dollars/pounds/euros (or whatever your native currency is.)
Aiming for 3% to 5% per day right now might sound like pocket change, but if you can become consistent enough to do that on a regular basis (and balance it out with losing days that are 2% or smaller) then you would have the potential to grow your account into a half-million or more. Remember, it’s all about compounding — even if you withdraw parts of your profits for short term use.
THE RISK-REWARD CONUNDRUM
As a serious trader, you need to drill into your head that there’s no way to avoid losses altogether. It won’t happen. No one on Wall Street or in London can do it even with decades of experience, and teams of researchers. In fact, it’s not a prerequisite to making (and keeping) profits in the markets. The only prerequisite is that your losses must always be, on average, smaller than your gains — over any given period.
(In some trading styles, larger risks are taken to gain smaller but more frequent profits. These methods are generally used by scalpers who shoot for high probabilities. As long as the winning trades are frequent enough, the net effect is the same as saying that any given set of ten trades always has a smaller loss than the average set of ten winning trades’ profits. As a beginner, it’s near impossible to shoot for a technique like this so don’t try it yet. I hesitated about mentioning this at all, but for the sake of providing information that’s more complete and real than most of what’s out there these days, I decided it’s worth mentioning for some of the more advanced readers.)
Here’s the main problem faced by most traders: If you try to trade with stop losses that are always smaller than your profit targets (good risk-reward ratio, in theory), you end up being more likely to get stopped out even in trades that end up hitting your target.
It’s a balancing act. You can’t expect to find a way to eliminate all scenarios like that, but you can try to optimize your method to avoid it as much as possible — that’s where the experience and technique comes into play. (I’ll get into this in more detail as we go deeper into this section.)
To elaborate: Imagine that we always trade with a 5 pip stop loss and a 10 pip profit target. In theory, this is a good risk-reward ratio (every winner, 10 pips, is twice the size of every loser, at 5 pips.) The reality is that the market, with all else being equal, is more likely to swing 5 pips in both directions before hitting your 10 pip target.
(Note for advanced readers: To be fair, some of the same strategies used on much larger scale — say, for example, a 200 pip stop loss and a 500 pip target — can actually avoid some of these pitfalls because that 200 pip stop can be placed very safely behind a long-term support or resistance zone. For the beginners, this will become clear as you learn — for now, it’s just something I wanted to mention for readers who might object to my over-simplified 5/10 example above.)
Before I end off this introduction to money management, it’s worth hammering in a point that far too many beginners seem to overlook…
THINK PERCENTAGES, NOT PIPS
For the sake of illustration, let’s say you trade two styles: A daily breakout that relies on a morning range, with stop losses between 20 to 40 pips; and a longer term technical analysis method, based on daily or weekly charts, that have stop losses between 100 to 300 pips.
At face value, to most beginners, the long term method sounds more “risky.”
If you thought so too, then please do yourself a favor and stop trading right now. Learn to position size properly before you touch another live account. Seriously.
With a proper money management method, there’s always a consistency between trades regardless of their time frame and size of stop losses.
(In some cases, you might risk more on a trade that you have more confidence in, or some other unique risk management model, but that’s besides the point here — for the sake of this discussion, I’m illustrating just how ignorant it is to assume that a 300 pip stop is always more risky than a 30 pip one. It isn’t by a long shot, but I’ll start with the most basic reasons.)
So for the sake of simplicity (in explaining the concept), let’s say that you’ve decided to risk 2% of your current account balance on each trade — the most commonly recommended risk management method (I said the most common… not necessarily the best for you or me.)
If your account balance is $2000 USD to start, then 2% risk is $40. So, as of this given moment, your maximum risk per trade would be $40.
Trade #1 — the one with a 30 pip stop loss, 60 pip target
40 / 30 = 1.3333
Multiply 1.3333 by 10,000 = 13,333
You need to trade this with a position size of 13,333 units of currency, which is $1.33 per pip.
(Note: In most platforms, 13,333 would be 0.13 standard lots, or 1.33 mini lots or 13.33 micro lots. Either way, you might need to round up or round down. Get into the habit of rounding down in situations like this, because that $40 risk might end up being equivalent to $4000 or more to you some day.)
Trade #2 — the one with a 300 pip stop loss, 600 pip target
40 / 300 = 0.1333
Multiply that by 10,000 = 1,333
So you need to trade this one with only 1333 units of currency, which (rounded down) is $0.13 per pip.
The second trade might sound ridiculous to you (it does to most institutional traders too, obviously) but your little 1333 unit trade is actually possible now, with the fractional-mini and micro Forex accounts available on the internet now.
The point is that both trades should do the same thing to your account: If you lose, you lose $40. If you win, you win $80. Yes, that applies to both trades.
The part that you may not realize is that the trade #2 (300-pip risk / 600-pip reward) can actually be less risky than trade #1 (30-pip risk / 60-pip reward).
For example, if trade #2 was executed near a very strong support zone that hasn’t been broken in years, so your 300-pip stop is outside of (past) that support and your 600-pip target is within a long-term range that’s been sloshed around a lot, you’ve actually got fairly high probabilities on your side despite the smaller stop loss.
On the other hand, with trade #1 (30 pip stop, 60 pip target), it takes a lot of experience, timing, and a bit of luck, to actually enter a day trade like that and maintain high probabilities. Short term price action can get slammed back and forth by unforeseen spikes and news reactions, or even typical intraday volatility, that can easily take your stop out before hitting your target. (Sure, a spike can hit that stop in trade #2, a few hundred pips outside of an unbroken long term support — but those odds are far, far better in your favor. If you don’t believe me, try trading a 30-pip-stop/60-pip-target method in a demo account for a while, and see how often your stop gets hit.)
Trading is about planning for, and reacting to, a set of “What if…” scenarios. Treat every trade like it might be the last one you can afford to lose — it’ll keep you from making the stupid (and money wasting) mistakes that plague beginner adrenaline junkies everywhere.
Filed Under Risk Management | Leave a Comment
Tagged With currency trading, Fibonacci Trading Strategies, forex, forex money management, forex traders, lot sizing, money management, position sizing, professional traders, profit target, ratio, Risk Management, stop losses, targets
Comments
Leave a Reply