Most traders only focus on the trading strategy compared to money management to gain profit. That's unfortunate and this is why.
Many traders tend to overlook money management. They put more importance on trading strategies that they think have a higher influence on their profitability. It may be right if we're talking about a single trade, but not if we want to profitable in the long term. Consistent result of trading in the long term depends on the implementation of effective money management.
A professional trader and forex mentor Nial Fuller once said that money management is the real "holy grail" in trading. He spoke from his trading experience and his years of forex teaching to his followers.
In some people's minds, money management is like something boring to discuss. It is not interesting and does not have a direct relation to the benefit amount gained in a trading position. Usually, money management is considered as a delayed matter that can be learned later, when a trader wants to increase his profit or rearrange his portfolio in a trading account.
The above opinion is true if you can gain a consistent profit. Even if your trading result is always positive, it is not a big deal if you do not apply the money management. But, what if your profit is not consistent?
Money management is one of the important factors in forex trading that deal with risk control. Trading is a kind of business and every business comes with a risk. Regardless of our capital, all of us want to limit the risk that might happen. Learning how to control the risk well is a successful key to gain a consistent profit in the long term.
Many beginners fail in their early years due to the lack of money management. Most of them even avoid using money management completely for some obscure reasons. If you feel the same way, it is better to start changing your mindset. Applying money management is crucial whether you like it or not.
A trader who neglects money management will be left clueless should their prediction goes wrong. Just assume that you have an updated trading strategy in trading, so you think you will face the 'perfect' market for your strategy; will you enter the market by bidding all of your capital in your account? Well, this is the perfect time to use money management proportionally and effectively.
Here are some key tips on money management that you can consider using in your trading.
1. Manage Risk Consistently
No risk amount is fixed for every trader. It is different from one trader to another as everyone has different risk tolerance. One thing for sure, use your spare money and avoid trading with your monthly budget. Consider that your capital for forex trading is the money that can be let go, so you will not crumble in a depressive state if you lost big time.
See also: How Much Money Do I Need to Trade Forex?
For the bigger picture, a professional trader who has income only from trading (such as stock, exchange, option, etc) will take risk more than 3% from his capital. Many experienced traders recommend the risk amount from 3% to 5%. However, the amount of risk you decide should make you comfortable. If it is smaller than 3%, then so be it.
The amount of the risk is defined by the money value, not the pips. Usually, it is defined in the percentage of the capital or balance in our trading account. Just consider that we are not in the trading position and have the intact balance in our account, we can say that the risk amount is the loss amount in an open trading position.
Unfortunately, setting the risk tolerance inconsistently often happens and it is a prime example of bad money management. Yet, it is normal and natural. After you get sufficient profit continuously, your risk aversion might decrease. You will tend to feel overconfidence.
However, your profit and loss probability will follow the random distribution pattern despite your excellent method and strategy. In other words, there is no standard and logical reason to claim that your profitability is always big, or your loss probability will be smaller. All we can say is there is no defined reason to change your risk tolerance, speaking from a psychological perspective.
We tend to like gambling, and it is difficult to control our euphoria or overconfidence. Even Richard Dennis, a famous trader, experienced a similar thing that almost ended his trading career. Therefore, Richard Dennis suggests that being consistent is important, especially in sizing your risk management and avoiding your trades being taken over by destructive emotions.
How to do Position Sizing Correctly?
If you want to set your risk management correctly, you may need to convert the amount of risk determined in money value to a lot size (representing the trading volume in the MetaTrader platform).
With the position sizing, the risk amount in money value will be always the same regardless of the stop loss amount in pip. The trading volume can be managed based on the stop loss that fits you. For example, you trade in a Standard Lot in EUR/USD pair, so the value per pip is $10. With a capital of $25,000, the risk amount for one position is set at 4%. The risk value will be:
$25,000 x 4% = $1,000
Let's say your analysis results in a 50-pip stop loss, the trading volume in Standard Lot is:
$1,000 / (50 x $10) = 2 lots
If there are two traders with different capital decide to have the same risk percentage and stop loss, the lot size will surely be different. The trader with bigger capital will have a higher trading volume, although their stop loss amounts (or the risk value in pip) are the same.
2. Withdraw Your Profit Regularly
To keep calm and not to be attempted in changing your risk management, it is better for you to withdraw your profit every month. A professional trader who earns from the market always withdraws a part of his money every month to neutralize his balance in his trading account. He also does not want to take a higher risk when he's in a winning streak.
By maintaining the account balance in a neutral state or an equilibrium point, you do not need to double-up the risk. Equilibrium is a fixed amount and the most convenient point to do a transaction. Stick to the well-tested trading plan, or rearrange your trading plan with the maximum risk that you can afford until a new equilibrium is reached.
See also: How to Build a Winning Trading System
3. Avoid Moving the Stop Loss
Moving the stop loss to the same level as the entry-level is acceptable only if you have logical and acceptable reasons. Have you ever experienced the case, when the price move as you predict after the stop loss successfully moved to the breakeven level? If you have experienced it, it means you give less space for the market to move. Usually, it happens due to the fear of loss. Emotional impacts negatively affect trading if they are not handled well. Bad money management might ruin your trading if you let your emotional side takes over the trading.
However, there are certain conditions that allow you to move the stop loss. You can move the stop loss level to the breakeven level if the price movement follows these scenarios:
- The price movement leads to a change in trend direction.
- The price moves closer to key resistance or support levels.
- There is a high-impact release. You are surely unable to anticipate the price movement direction before, during, or just after the news release. Considering the high volatility, it is better for you to move the stop loss to a breakeven level if.
- You have a floating position for a few days, but the market price moves very slowly or even stops moving. In this case, you can consider getting out of the market or move the stop loss level to the breakeven if it is possible.
4. Don't Aim Too High
The risk/reward ratio is the comparison between the targeted stop loss (risk) and the profit (reward). If in the previous discussion we have determined the risk and the lot size, this step is about determining the profit that we want by comparing it to the risk decided before.
Similar to the risk, to decide the profit target, there is no fixed or formal policy we should follow. We just need to be strictly objective and realistic based on the market condition at that time. An experienced trader suggests that the risk/reward ratio is best to set at 1:2. In other words, if the stop loss is 50 pip, the profit is 100 pip at least. Or you can also try the 1:3 ratio or more. The bigger ratio used, the more profit you can get.
A professional trader, Marty Schwarts, advised not to level-up your position size unless you double-up or triple-up your account balance. Many traders make a mistake by increasing the lot size when their balance hasn't increased yet. Sadly, this mistake often leads to a margin call situation.
Therefore, aiming for profit should not be set too high if you are still a beginner. You can try the beginning value at 1:1.5 (or any other ratio bigger than 1:1), then increase the ratio only after your trading balance sees a consistent raise.
If we apply the risk/reward ration consistently, in the long term we will get sufficient return although our entire profit percentage is less than the loss. Let's say, 70% of the total position of a trader experiences loss. Don't just see his bad luck, but consider the ratio between the profit and the loss. Surprisingly, he's got a 15% return from his total trading position. How come? It is because he applies the risk/reward ratio of 1:2 in every position.
The important thing in applying money management is: decide the risk first then set the profit you aim.
5. Know the Right Time to Re-arrange Risk/Reward Ratio
Sometimes, the market shows a drastic change in daily fluctuation. Although it rarely happens, we can use that moment to reset the risk/reward ratio as best as possible. The analysis knowledge of the price fluctuation is needed for knowing the right time to gain a lot of profit in trading, especially when the market condition is in trending position.
See also: Reading Market Situation
You can do this suggestion by monitoring the bar formation and the price action on the key level (resistance or support). Here are the further details:
When the Breakout is Strong
When the market reaches final consolidation, normally market consensus to break the price will be realized. If the formation bar is in a convincing breakpoint, the breakout happened will be very strong. You need to pay attention to the false breakout first before deciding to enter a trade in the breakout. The example of a strong breakout is as follows:
The picture above shows the signal of a strong breakout after the price reaches the resistance level. Focus on the candlestick bar formation and their 'tails' before the inside bar, which shows the strong momentum before the prices reach the resistance point. The pin bar formed then experiences the rejection on the key level. It confirms the signal of an upcoming strong uptrend. In this case, the risk/reward ratio can be set higher until the next resistance level.
When the Signal Shows Trend Continuation
When the market movement condition is in a trending position, the signals showing trend continuation has very high profitability. For example, the pin bar and the inside bar formed on the moving average line below shows the strong trend continuation. On those levels, the risk/reward ratio can be increased.
When a Price Action Happens Around a Key Level
The setup of price action that happens near a key level, such as support or resistance, will be a valid signal showing that a strong trend will occur. If it happens on the trending market condition, such as the following XAU/USD daily chart, there is a high chance of a trend continuation.
The fakey bar (false bar) on the downtrend moving average is confirmed with rejection at the resistance level and it shows the very strong bearish sentiment after the consolidation. In this case, the risk/reward ratio can be set at the maximum level at the next support level. For maximizing the risk/reward ratio, you need to be patient because the valid signal mostly happens in the daily time frame.
Trading strategy and money management are equally important in the trading plan that must be applied simultaneously. They synergize each other as money management will run better if you master and believe in your strategy. If both of them are applied well, profit will consistently overcome your loss in the long term.