Money Management Part 2:
In the first of these articles on money management we looked at the importance of proper money management which we illustrated through recovery as a percentage of drawdown analysis. The good news is that even though theories on money management range from highly complex portfolio theory is simple common sense methods, for the majority of traders simple systems are usually the best. As a simple system with is more easily implemented, it is more likely to be used consistently and thereby contribute to your long-term success as a trader.
1. Keep your risk small using a maximum of percent of your equity on any individual trade. There are many successful and wealthy traders who limit their risk to 1% or less so it is wise to follow these patterns of success.
2. Always use a stoploss on every trade. Mental stops are a total copout they do not work and are purely a means for a trader to manufacture reasons for him or herself to delay the inevitable in the hope of not being wrong. The more rapidly you can recognise when a trade is not going according to plan and close it the better off you will be. A good question to constantly ask yourself is: Based on what I see at the moment would I get into this trade now, if the answer is no then you should no longer be in that trade.
3. There are many economic, political, geological and other unknowns out there that can turn the market upside down in an instant so it is a good idea to limit the risk on all your open (at risk) positions to a maximum of 10 %. Then in the event of a catastrophe that stopped out all your open positions would still have 90% of your original capital available to take advantage of whatever new circumstances had come about.
4. Risk reward is the other side of the equation, at a minimum should be 2:1 or preferably 3:1 or greater. That is if you are risking 10 pips in a trade you should be targeting an average 20 to 30 pips. When you examine the risk reward ratio that most robots use like risking 300 pips to make 10 to 20 pips or less it is easy to see how, dependent upon timing, they may appear to work at first but eventually wipe out people’s accounts.
5. Never add to a losing position. Some traders indulge in what is called averaging down, when they take a position expecting the market to turn and it does not. Holding onto that belief they take additional positions as the market continues against them. This can lead to financial disaster; it totally destroys risk reward ratios and throws money management right out the window. As one wise trader stated, the market can remain irrational for longer than you can remain solvent. When the reason you entered the trade proves to be invalid close the trade.
6. Endeavour not to set arbitrary stops, ideally stops should be based on market conditions taking into consideration volatility, recent swing highs or lows, support and resistance levels or other logical points that give the market room to move, allow for the spread but are only so far from your entry as is needed to invalidate the entry or timing of your position. It is also necessary to consider whether the target required by your risk reward ratio has a good probability of being met in the current market conditions, if not do not take the trade.
7. Correlation is another important factor to take into consideration when looking at individual trade exposure. If you take a position on to highly correlated currencies you are effectively doubling your exposure to the same risk as the price movement of both pairs would be virtually the same. I will cover all correlation in depth in another article, but here is a classical example of both negative and positive correlation. The GBP/USD and EUR/USD are positively correlated. Which means when the euro goes up the pound also goes up. The EUR/USD have a high negative coefficient (-0.90) so they move in the opposite direction. Most of the time. So if you were to trade negatively correlated currencies at the same time the profits on one trade would likely be offset by corresponding losses on the other.
8. Nobody ever went broke taking a profit. The only things that you have control of when trading are the timing and placement of your entry and stoploss. The market will decide how much profit you make. Knowing this, it is wise lock in a portion of your profits as the trade progresses. There is nothing more frustrating seeing a trade that was profit suddenly turn to a loss. Another aspect of this is managing your stops. As a trade progresses it is advisable to reduce your risk by reducing your stop while still leaving room for normal market fluctuations. There is nothing more freeing than watching a trade progress you have taken profit and moved stop to breakeven.
9. The greater the trade frequency and the smaller the timeframe of your trades, the less that it is advisable to risk in each trade and the more important it is watch the spreads and achieve your targets as you cost of taking each trade are very high portion to your likely return.
10. Being adequately capitalised is essential to your long-term success. What I mean by this is that the capitalisation must be sufficient to realistically enable you to meet your expectations. If you expect to make a good living and pay your bills with a $5000 account then you are setting yourself up failure. I am not saying you can’t turn a $5000 account into an amount sufficient to be able to live off. However, it will take time to build your account to a point where it will provide a very good living. Every system, no matter how good, will have periods of drawdown, if you are unfortunate enough to hit that drawdown period right at the start, you would then be severely undercapitalised financially and possibly psychologically. For new traders this can tempt them into increasing their risk, grabbing small profits and being very hesitant even when all the elements of their edge are present. This becomes a vicious circle leading to further drawdowns that would otherwise not have occurred, and is usually followed by the trader abandoning a system that would otherwise have worked had trader continue in accordance with the systems rules.
11. Personally, I do not like pyramiding into positions, however if you are going to do so it is important to do this properly, which means the first position placed should be your largest and additional positions added should be progressively smaller that way when you’re stops are eventually hit the profits on your initial positions should substantially outweigh the loss your final position.
14. Knowledge and understanding: What would be your chances of winning a game of chess set down to play an experienced player and had neither the rules nor any experience? I would estimate about zero. Would you jump into deep water if you did not know how to swim? To begin any endeavour you need at least some knowledge about what to do. To do well at anything requires time and practice. Forex trading can provide you the means to become independently wealthy and enjoy a life of great freedom. It can also do this with much less time and cost than almost anything else. But if you’re not prepared to invest the time and effort needed then you are condemning yourself to failure. Mistakes are inevitable even necessary in the process of learning. When you are trading with a live account your losses can be turned into profits by accepting responsibility for the result, examining the trade to see if you missed any of the elements that constitute your edge or whether it was just the normal unpredictability of the market. The knowledge gained in honestly examining losing trades is what will give you the necessary understanding how long and prosperous trading career.
15. If you are experiencing a drawdown period or have had three or more unsuccessful trades in a row, evaluate your recent trades in the current market conditions. Sometimes in focus to closely on the immediate market and lose sight of the big picture. It may have been a change in trend, you may have missed vital clues as to where the market was going simply not following your rules 100%. You must be willing to examine yourself and all possible reasons for the losses. The market will be there when you are done and psychologically the break can be just what is needed to get you back on track.
16. Knowing that when you open a trade anything can happen and knowing this at an emotional and psychological level as well is intellectually is essential for your survival. You really understand this then you will have no issues or concerns about being wrong and have issues about admitting that you are wrong stay in trades too long or find ways to justify incorrect actions and this will greatly interfere with learning to trade successfully. Losing trades can not only deplete your financial capital. It can also deplete your psychological capital and this can be by far the greatest loss as confidence is essential to winning. Accepting that anything can happen means being able to accept being stopped out of any or all of your trades and be comfortable the potential loss. If you cannot accept this then it is essential to reduce the amount you are risking on your individual and collective trades to a point where such loss would be acceptable.
As you can see money management does not need to be complicated it really comes down to understanding and accepting the risk involved in trading, ensuring that the risks you take on any trade are small and your total exposure is never more than you can afford to lose. This is not by any means a complete list. However, it should help you through the majority of difficult situations. To survive and establish yourself as a successful trader you will need to study your craft and the risks associated with it. I cannot emphasise enough the psychological aspects of trading and this will be the subject of a number of articles in the future.
In the last article of this series on money management, I will introduce you to the thoughts and insights of some long-term successful traders. Success leaves clues why not follow them.