Money management is critical to your success as a professional trader. Quite simply, it means the difference between being a winner and a loser.
It has been shown that if 100 traders start trading using a system with a 60% winning ratio, only 5 of those traders will be in profit at the end of the year. In spite of the 60% winning system, as many as 95% of traders will lose because of their poor money management. Money management is the most significant part of any trading system. Most of traders don't understand how important it is.
It's important to understand the concept of money management and also understand the difference between it and trading decisions. Money management represents the amount of money you are going to put on one trade and the risk you’re going to accept for this trade. It
has nothing to do with where you enter or exit a trade; only how much risk you are willing to accept on that particular trade. There are different money management strategies. They all aim at preserving your balance from high risk exposure.
To begin to understand money management, you should understand
the following term: Core Equity
Core Equity = Starting Balance minus Dollar Amount in Open Positions. If you have a balance of $10,000 and you enter a trade with $1,000 of risk, then your core equity is now $9,000. If you enter another $1,000 trade while the first trade is still open, your core equity now becomes
$8,000. It's important to understand what's meant by core equity since your money management will depend on this equity.
Next I’ll explain one model of money management that has proven to assist in delivering a high annual return with limited risk. The account that we will use as an example will be a standard account with a balance of $100,000 and 20:1 leverage. You don’t have to have this much money in an account to use this strategy, it can be adapted to fit any size trading account including mini-accounts. What is important is you understand the theory behind the method.
MONEY MANAGEMENT – BASIC CALCULATION OF POSITION SIZE
The first thing to understand about money management is you should choose an acceptable amount of risk for your trading capital. Your risk per trade should never exceed 3% per trade. It's better to adjust your risk to 1% or 2%. Most professional money managers prefer a risk of
1% but if you are confident in your trading system and you have a personality of more of a ‘risk taker’, then you can raise your risk up to 3%.
1% risk of a $100,000 account = $1,000
You should adjust your lot size on the trade so that you never lose more than $1,000 on a single trade. Here’s an example:
If you are a short term trader and your system calls for a 50 pip stop loss on the pair you are going to trade:
If you are willing to risk 50 pips with a total loss of $1,000: 50 pips = $1,000
1 pip = $20 ($1,000 divided by 50)
The size of your trade should be adjusted so that you risk $20 per pip. With 20:1 leverage, your trade size will be $200,000 or two standard lots. (If you were trading a $10,000 account with the same scenario you could trade .2 [two tenths] of a standard lot or 2 full mini-lots).
If the trade is stopped out for a loss, you will lose $1,000 which is 1% of your balance.
Here’s another example: If you are a longer term trader and your system calls for a stop loss
200 pips below/above your entry point on a currency pair: 200 pips = $1,000
1 pip = $5
The size of your trade should be adjusted so that you risk $5 per pip. With 20:1 leverage, your trade size will be $50,000 (5 mini-lots or .5 standard lots).
If the trade is stopped out for a loss, you will still lose $1,000 which is 1% of your balance.
These are just examples. Your trading balance and leverage provided by your broker may differ from this formula. The most important thing is to stick to the 1% risk rule. Never risk too much in one trade. It's a fatal mistake when a trader loses 2 or 3 trades in a row, then is confident that his next trade will be a winner and he may take a larger position in this trade. This is how you can blow up your account in a short time! A disciplined trader should never let his emotions and
greed control his decisions.
DIVERSIFICATION
Trading one currency pair will generate few entry signals. It would be better to diversify your trades between several currencies. If you have $10,000 balance and you have open positions with $1,000 then your core equity is $9,000. If you want to enter a second position then you
should calculate 1% risk of your core equity… not of your starting balance! It means that the second trade risk should never be more than $90. If you want to enter another position and your core equity is $8,000 then the risk of this trade should not exceed $80.
It's also important that you diversify your orders between currencies that have low correlation.
For example, if you have a long EUR/USD trade then you shouldn't go long GBP/USD since they have high correlation. If you have long EUR/USD and GBP/USD positions and are risking 3% per trade then your risk is 6% since the trades will tend to end in same direction.
If you want to trade both EUR/USD and GBP/USD and your standard
position size from your money management is $1,000 (1% risk rule)
then you can split the amount between the trades; $500 EUR/USD and $500 GBP/USD. This way you’ll be risking 0.5% on each position. You’ll be able to take both trades but still stick to your money management rules.
