Still finding money management is a hassle? Here you can learn how to implement and optimize money management in an easy way, and why completely abandoning the strategy is a big NO.
Picture this: two inexperienced traders are provided with the best high-rate system and they trade in the opposite direction of each other. It would be very likely for them to lose money. Now, if they are replaced by two seasoned traders, it is quite likely that both traders will end up growing their money. Why do these happen? Because there is a factor that separates the pros from the amateurs: money management.
The problem is, money management is considered a nuisance by most traders. Everyone knows its importance, but few actually practice it with discipline. Traders like this are not unlike children who wouldn't eat their vegetables despite the many benefits. That's because it requires them to closely monitor their positions and take losses into their account; unpleasant things to do.
|Equity Lost||Return Necessary to Recover|
The table above shows how difficult it is to recover the lost equity. For a 25% loss in equity, the amount of return to restore it is only 33%. However, as the loss grows bigger at 50%, traders have to gain 100% of their capital, which is only achieved by 1% of traders worldwide. Traders who endure a 75% drawdown will face a gargantuan task as they must have a 400% return on their reduced capital just to break even. At 90%, it becomes an almost impossible mission.
In Pursuit of "The Big One"
The numbers above are quite well-known to most traders but ultimately ignored. There are many cases of traders who lose years' worth of profits in one disastrous trade. This is usually due to careless money management, with no placed stops and many average downs into the long positions and average ups into the short positions. Ultimately, the loss occurs as a result of overtrading.
Most dive into forex trading with a dream of achieving "The Big One", the one defining trade that wins them millions and allows them to retire young and rich. The story of George Soros aka "the man who broke the Bank of England" who, in 1992, placed a huge short position in Pounds and earned a $1-billion profit in a single day convinces many traders that their fantasy could turn into reality. But the reality is often disappointing. Instead of "The Big Win", most traders suffer from one "Big Loss" that delivers the finishing blow to their entire trading career.
Lessons Learned the Hard Way
Larry Hite, a day trader, and trend follower writes in Jack Schwager's best-selling book Market Wizard:
"Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade."
This is a wise piece of advice. Even when traders suffer 20 consecutive losses, they will still have 80% of equity left if they apply that rule. Another sensible advice that beginners can follow is to not use money in the amount that may impact their living conditions should the money is lost completely. Unfortunately, only a few would follow this principle religiously. Like children who learn to stay away from hot stoves only after getting their hands burned, traders sometimes need to experience how it feels to lose real money for their learning process. That's why it's very crucial that you use the amount of money that you feel comfortable to lose as the trading capital when you first enter the live market.
Money Management Styles
In general, successful money management can be practiced in two methods. The first method is by taking many small stops frequently and gaining profits from a few winning trades. Traders who practice this method experience many cases of minor psychological pain in exchange for a few major moments of joy. The second one is by taking in large stops infrequently and gaining many small profits. With large stops, it is pretty common to lose weeks or even months’ worth of profits in one trade or two. This method gives traders many minor moments of joy, but they have to endure severe psychological blow.
Whichever method you select ultimately depends on your style and personality. It is a process of self-discovery in forex trading. Thankfully, you can choose either method equally as forex brokers charge no extra cost to traders. Forex markets are spread-based, meaning that the cost of each transaction is the same regardless of the size.
For example, a broker charges a spread of 3 pips in EUR/USD, which is equal to 3/100th of 1% of the underlying position. If you want to trade 100,000 units, the spread will be $30, and if the lot size is 10,000 units, the spread will be only $3. Regardless of the size, the cost of forex transactions is uniform in terms of percentage. With corresponding commission or spread, forex traders can practice money management styles without having to worry about variables in transaction cost.
Four Types of Stops
If you are prepared to trade your hard-earned money with a money management approach, these are four types of stop orders you can take into consideration.
1. Equity Stop
Equity stop involves risking a predetermined amount of equity in the trading account. Traders commonly set the risk percentage at 2%. For example, if you have $10,000 on your account, the risk you take is $200 or 200 points on a mini lot (10,000 units) of EUR/USD or 20 points on a standard lot (100,000 units). For a more aggressive trade, an equity stop of 5% is the uppermost level you can place. With this percentage, ten consecutive losing trades will result in a drawdown of 50% from the initial equity.
Although this type of stop is very easy to implement, it draws criticism for its potential of random placement of exit point; it will lead to an exit strategy that is determined by the money management rather than by the logical response to the price movement.
2. Chart Stop
Chart stop makes use of indicator signals or price action on the charts. Traders who use technical analysis tends to combine the exit point with equity stop rules and chart stop. The most common technique of chart stop is the swing high/low point. For instance, A trader with a $10,000 account and a maximum of 2% equity stop would measure the swing points before placing a stop loss. Say the previous swing high is at 1.3704 and he is about to short a currency, the price range in which he should enter the market should not be lower than 1.3504 (200 points or about 2% of the account).
3. Volatility Stop
As the name implies, volatility stop uses volatility instead of price action to set the risk. In a highly volatile market, the price will change drastically. Traders will have to give the risk more room in order to avoid being stopped out. Correspondingly, in a low volatility market, traders will need to compress the risk.
See Also: Currency Pair, Liquidity, And Volatility
Traders can use Bollinger Bands as an ideal parameter to determine market volatility. Bollinger Bands is a tool that can measure volatility by calculating standard deviation. In a high volatility situation, traders can set stops below the swing low (the lower band) or above the swing high (the upper bands), then scale in positions for better "blended price" and faster breakeven point. It should be noted that the risk should not be more than 2% of the account. Setting a trade with smaller position sizes is recommended so that the cumulative risks are still within traders' comfort zones.
4. Margin Stop
Margin stop is probably the most unusual yet very effective money management style. Since forex operates 24 hours a day, brokers can close traders' positions immediately after the margin call is triggered. That's why forex traders are not at risk of having a negative balance in their account as the platform will automatically exit the trades.
In this type of stop, traders divide their capital into 10 equal parts.
For example, if you have $10,000 to fund your forex account, you deposit only $1,000 and keep the remaining $9,000 in your bank account.
- A $1,000 deposit would allow you to control one standard lot (100,000 units) with 100:1 leverage. Keep in mind that you will receive a margin call if the price moves 1 point against your trade since $1,000 is the minimum amount required by the broker.
- Or, you may want to trade only 50,000 units that will give room for almost 100 points. A lot size of 50,000 units require $500 margin, so $1,000 – 100-point loss* 50,000 lot = $500.
In the end, it depends on your risk tolerance. Regardless of the leverage ratio you take, portioning out the fund would save your account from total destruction in just one trade. It would also allow you to try on a potentially winning system without worrying about setting manual stops.
Money management is the most significant aspect for traders in forex trading, representing the amount of money you will put on a trade and the risk you can accept for the trade. It is varied as it is flexible, and you will eventually find one that suits you the most. The key is to practice it with discipline so you can generate profits in the long term.