Money Management Principles You Need to Know

Forex Money Management

All profitable trading strategies focus on money management. Regardless of how talented you are as a forex trader, if you don't adhere to any kind of money management you will at some point empty out your trading account.

Preemptively limiting your losses and selecting some kind of exit strategy for rewarding trades ? as discussed in the last chapter ? is really only 50 percent the story when discussing how to protect your bankroll.

Position Sizing

In his outstanding book with the most awful title ever created in the history of mankind (better that than the other way around) Trade Your Way to Financial Freedom, trader and psychologist Van K. Tharp covers the importance of position sizing and expectations (Expected Value). Tharp claims that what is generally regarded as to be money management is in itself an inadequate guarantee when it involves protecting your trading funds. For instance, when you stick to the rule of not risking greater than 3 percent of your trading capital, you would be exercising money management, but it does not automatically offer sufficient protection for your trading money.

Perhaps you're a long-term trader in a extremely volatile market, stopped out 10 or 15 times consecutively sometimes. Not everybody can bear losing 45 percent of his trading capital prior to one fat, juicy trade arrives to make it okay again. (aside from the question if a trading system with a probable drawdown of 45 percent can even be considered a feasible trading system). Quite simply, different personalities and trading strategies ask for different approaches.

Tharp approaches the concept of money management not passively but interactively. What type of trader are you? In what sort of market are you active? How large is the peak through drawdown (losing streak) that you could manage, emotionally speaking? How much money is your system making? Tharp takes the solutions to these questions collectively to allow traders to develop their own, optimal money management tactic. Of course this is far away from conventional money management.

Central to Tharp is position sizing, which he sees with regards to the risk/reward ratio. There are a number of position sizing strategies, but the right one expresses position size as a percentage of entire trading capital. It's critical to understand that the size of the position is unimportant here (it could be 100% of your entire trading capital); what is important is the amount that is actually in danger. In most cases,Tharp looks at three percent of total trading capital at risk to be extreme, but it also depends upon other aspects of your trading system. As an example, if you really hate losing trades and develop a lucrative system that generates 90 percent winners (which is achievable, but they will possibly be small winners most likely) and only small losing trades, it wouldn't be an issue to use position sizes where 5 percent of your trading funds is at risk. In the end, your peak through drawdown would already be restricted by the small percentage of losing trades.

The most important goals of position sizing:-

  1. Guarding your trading capital
  2. Allowing you to determine your Expected Value (EV)
  3. Allowing you to adjust your trading system, to enhance the expected value and reduce the risk of ruin.

Example
Trader Y has a trading system that generates about 50 percent winning trades. He is a short-term trader, has a forex small account (1 pip = $1) and primarily focusses on trading the EUR/USD. He doesn't have a lot more information about his trading method yet, with the exception that he has already lost half of his bankroll and has the impression he's doing something incorrect.

After a little investigation, he finds out that his profitable trades typically net him around 30 pips, while his losing trades cost him 60 pips because he constantly puts his stop loss 60 pips away. He began with a trading capital of $600, but now merely $300 is left.

Trader Y's position size is as a result 10 percent (60 pips = $60 in a mini account) of his entire trading capital. Or, more precisely, it used to be 10 percent, since now that his trading capital is right down to $300, his position size of 60 pips per trade has in fact increased to 20 percent of his total trading money! Another 5 losing trades back to back ? quite possible with a 50/50 system ? and he will probably be broke.

There are a number of things wrong with Y's trading system.

  1. His position size of 10 percent is much too large and aggressive, especially due to his 50/50 system.
    Everyone who has ever experienced or even observed a little roulette in the casino, knows it's not that unusual for the little white ball to find a red number ten times consecutively, in which case Y would go bankrupt.
  2. Because trader Y doesn't modify position size to his decreasing trading capital in any way, his percentage of trading capital in danger continues to rise and is by now up to 20 percent.
  3. Evidently, trader Y doesn't look into his risk/reward ratio whatsoever, because he is consistently risking 60 to win 30. You don't need to be a mathematical genius to comprehend this makes up a negative expected value.
    Protecting your trading capital

One thing is definite, if you burn your trading capital you are out of your game, and if you cannot trade anymore you could have the most amazing trading system on earth, but it sure as hell won't provide you any money anymore.

So, do a little digging and discover how usually you produce a winning trade as a portion of total trades and modify your position sizing (the percentage of total trading capital at risk per trade) appropriately. A great rule of thumb is to restrict your position size to a highest of 1/10 of the percentage of winning trades. For instance, if you have a method that generates 50 percent winning trades, your maximum position size per trade must not be more than 5 percent.

Remember that you need to modify your position size when your trading capital grows or shrinks considerably. It's not anything you have to adjust after every trade, that would be too unrealistic but after losing 25 percent of your trading funds it would be the wise thing to do to.
Expected Value (EV) and calculating your EVP

Minimizing risk of damage and having a process with a positive Expected Value (+EV) is what it is all about when playing games which can be structurally lucrative (at least for those who understand how to play them).

As said, minimizing your risk of ruin can be accomplished by hooking up the percentage of winning trades to the height of your position size. If you are at the start of your trading career and really have no clue of the percentage of winning trades yet, a great starting place would be to presume 25 percent winning trades and a maximum position size of 2.5 percent per trade (meaning 2.5 percent of your entire trading capital )
When trading the financial markets, Expected Value is a function of the proportion of winning trades, the normal earnings for winning trades, the normal loss for losing trades and the position size.

Example

  • You have a trading process that produces 40% winning trades.
  • The average profit for those trades is 50 pips.
  • Your position size is for the most part 4% of your entire trading capital (1/10 of the percentage winning trades)
  • Your entire trading capital is $600, meaning your position size in dollars would be for the most part $24 per trade.

Over ten trades, the outcomes, on average, would be the subsequent:

  • 6 x -$24 = -$1444 x $50 = $200
  • Total profit = $56
  • Expected Value = $5,6
  • EV expressed in position size (EVP) = 0.23

Expected Value indicated in position size (EVP) is nothing over the Expected Value for every dollar you risk. An EVP of 0.23 as a result means that on average you earn 23 dollar cent for every dollar you risk.

Expressing your EV in position size can be useful because it can you demonstrate to you how your trading system is doing over a longer time frame, no matter the (growing) size of your trading capital. With time, absolute values change, but by showing the EV in the value of the position size you can usually see the relative outcome of your trading system. In most cases, the higher your EVP, the much better your system is performing.

Conclusion

Many beginning traders possess zero trading system at all. They have not yet considered about what type of trader they desire to be (long-term, short-term, many small losses and several big winners, or many small winners and few losing trades etc) or how to determine whether or not they're on the right course. Often, their examination doesn't go much past “when my trading capital grows it's going well, when only 10 percent of my trading capital is left it's going poorly”.

This attitude/situation is understandable, when you've just found out trading on the forex there are a lot of things requiring your consideration, but can also be pricey. Developing a trading method is something that shouldn't be delayed until you're broke.

This chapter aims to present that it's critical to start contemplating your trading system immediately, to limit your risk, safeguard your trading capital and gain knowledge in the Expected Value per trade.

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