Trade Money Management

Here come the non-glamorous hard working nuts and bolts of trading, trade money management but none the less important.

How to manage your risk.

You see it does not matter how perfect you think your strategy is at some point in time it is going to go wrong. "Not mine" you might be saying to yourself. You might think that you have the perfect system that no one has ever thought of before. You might have back tested it till the cows come home and traded a demo account for months. It works, It works, It works! Oh and by the way you might think it's new but you can bet your bottom dollar somebody somewhere has thought of it before.

So you start live with your own hard earned cash. At first all looks great but then some sad day it doesn't. It all goes wrong and that last trade was enough to wipe out all your previous gains and then some.

If you do not have your trade money management in place you might win 9 out of 10 trades but the 10th trade will lose you more than the previous 9 winning trades. I see it happen all to many times. There are three things you need to be thinking about and we will be covering them all here soon.

What happens when my strategy goes wrong?

Having a stop order is an important yet simple way to make sure you do not over expose yourself to the market. We will never go into a trade thinking it will go against you but there will always be a time when it does. So our advice will always be "remember to place your stop loss orders" They will get you out of so much trouble, protect your capital and give you peace of mind. So it's worth saying again "place those stop orders at the time of placing your trades".

There are three types of stop order that you might think about.

1. The normal stop
2. The guaranteed stop
3. The trailing stop

All three have them plus point and depending how you look at things will depend on which one will be right for you. Let's take a look at what the differences are.

The normal stop:

When you place your trade the stop will be a point on the chart where you have planned to close out of the trade, therefore risking no more past that point. If the market starts to move against you and this point is hit your trade, with you losses, will be stopped and the trade will be closed. This means you have more control of your loss instead of just blindly leaving the trade and your account open to a greater hit. Sounds sensible right? You will be amassed at the amount of traders who think they can do without stops. They don't tend to spend that long trading as their account gets burnt very quickly.

The guaranteed stop:

The difference from the normal is small and will cost you a little too. Normally in the form of a little extra on the spread, a few more points on either side of the bid/offer price but some might say it's worth it. The normal way a trade is stopped out is seen in the example above. The market starts to move against you, your stop loss order is hit at the exact level you have stated and your trade is closed. The market though does not have to work like this. There is nothing to say that it has to move up or down in an orderly faction. If for example there is some unexpected news the market might "gap" in either direction especially after the weekend when the market has been closed. It tends not to happen as much to the forex as it does with the stock market but there is still a chance that you can be caught out by this. The way to protect yourself from this would be to use a guaranteed stop which would close your trade at the point you have chosen even if the market gaps pass this.

The trailing stop:

This does exactly what it says. You set where you would like the stop order to be and if the market moves against you it will stop you out at that point. If on the other hand the market moves in you favour and your trade goes into a profit then the trailing stop moves with it locking in some of your profit, good way to protect some of your profits by locking them in as early as possible.

Don't be fooled into thinking that the market might somehow know where your order is placed and move to stop you out of trade, so therefore don't set you stop orders. It just does not work like that. Instead remember not to place your orders to tight as you must give the market room to maneuver so that you don't get caught out in the general noise of the day. It might take you a while to judge how far to set your order on any given currency pair or time frame but it will come with experience and why we promote the use of a trading journal to help with things like this.

2. Risk-Reward ratio, is the trade worth making?

Understanding the risk reward ratio of all your trades is a must have parameter of any sensible money management strategy.

It is all too easy to lose money trading the forex. If you trade far too high a percentage of your account at once, before you know it, after only a few hard hitting trades your pot is empty. Or you might well have a high percentage of small winning trades, then along comes a large losing trade that again wipes you out leaving the pot empty and you wondering what happened.

As risk is a part of every trade it is a must for every trader to work out what he/she stands to gain versus their loss before you hit the buy button.

This means a trader should know, before taking a trade, how much of your capital you are willing to lose versus the potential reward or amount you stand to win if the trade comes good.

It's easy to work out so let's look at a few examples.

If the ratio is say 1:2 then for every unit you would potential loss you will be looking for a return of two units. So if you have set your stop loss order 20 points/pips away from your opening order then you would be looking for a gain of at least 40 points/pips.

If the ratio is 1:3 then for every 3 unit you would potential loss you would be looking for a return of three units. Again if you have set your stop loss order 20 points/pips away from your opening order then you would be looking for a gain of at least 60 points/pips.

Setting your parameters at 1:2 ratios is the leased you should be looking for. To put that into some context it would mean that if you were successful on 40% of your trades, which is not so out there, then in the long run you will be a profitable trader. "Wow that's less than half my trades and I can still be profitable" Yeah well that kinder reduces the pressure a bit doesn't it. This is where we go back to our psychology again, patience and self-control. Also how great is it to hear someone actually tell you that you don't have to be right all the time?

"Let your profits run and cut your losses quickly"

"Which risk-reward ratio should I be using?"

Whether you look for a return of two, three, four or even five times your potential loss is really down to you but as we have looked at 1:2 is a good starting point for beginners. Then as you become more experienced build on that and you will find that some trades offer more easily to three to four times your potential loss but always make the goal two. If you don't you will be just gambling your hard earned money away. Remember if the trade is not worth doing then be patient there will soon be one that is worthy of risking your money.

3. How much of my overall account should I trade?

Position sizing is all about how much, in terms of percentage amount of your overall account should you be willing to risk on a single trade.

Far too many traders make a huge mistake at the start by choosing to risk far too large a percentage of their accounts on any one trade. They have an over confidence that their new found knowledge is much greater than the average newbie and so believe they will achieve complete global domination of the financial markets inside one month. Only to find that after a limited amount of trades their trading careers come to an abrupt end and global domination is over before it ever really began.

That is why position sizing is so important to us all if we are going to get this right.

"So how much should I trade?"

Well we believe that most sensible positions on this would recommend that 2/3% of your overall pot should only ever be risked on any given trade. Now I know what you're thinking "it's going to take me years to buy that boat I have my eyes on" right? Well yours might not be a boat but you get the point, and the thing is as much as I hate to have to say it but at some point we all have a losing streak. So when this happens will determine your chances of staying in the market, will you be risking too much and be out? Or will you be using a sensible position sizing strategy and after you come through the other side of your losing streak still be in the market to reap the profits that will come your way. This is how we will achieve our long term goals.

For example if you have set your max risk at 2%, you would have to loose in theory 25 times in a row to wipe out only 50% of your account and how unrealistic is that? We would hope by the way, that you stop way before you hit 25 and evaluate your trading strategy to see what's going wrong but it does take away a lot of the stress when you adopt this approach to position sizing.

It's just simple math to work out how much to risk on a single trade.

For an account size of 500 and a risk of 2% the amount per trade would be 50
For an account size of 5000 and a risk of 2% the amount per trade would be100
For an account size of 10000 and a risk of 2% the amount per trade would be 200
For an account size of 500 and a risk of 3% the amount per trade would be 75
For an account size of 5000 and a risk of 3% the amount per trade would be 150
For an account size of 10000 and a risk of 3% the amount per trade would be 300

To help you with the calculations you could put everything into a spread sheet so that can automatically workout for you your position sizing. We will be publishing one here soon and we will be making it available to download for free if you're not sure how to go about that.

The most important aspect of trading must be to protect your capital, keep the risk of wiping your account out to a minimum so as to make it as hard as possible to lose over the long run. The aim is to take the stress away and to help you sleep at night no matter what happens. Trading should be fun as well remember.