Money management plays a pivotal role in forex trading. This article discusses three basic money management strategies to maximize profits effectively.

Money management is a non-negotiable factor for any trader who craves a successful career in the forex market. Beginners and professionals alike should practice money management consistently. With the proper money management strategy, traders will have the ability to manage their investment so that they do not take risks beyond their trading capacities; a dangerous situation that can lead to financial ruin.

 

Trading Risk and Money Management

The Cambridge Advanced Learner's Dictionary defines risk as "the possibility of something bad happening". In forex trading, "something bad" pertains to the loss of capital. Every time traders buy or sell currencies, there is no certainty about the return. The possibility of the actual trading outcome being the polar opposite of what traders expect will always exist.

When this possibility becomes reality, traders end up losing money and suffer the risk. Factors such as leverage, profit target, and trading cost also contribute to the risk. For instance, while leverage will magnify the amount of profits, it will also multiply the potential risk which in turn can result in losses that exceed the capital.

trading risk

It is important to note that the result of any trade depends on many variables and will remain uncertain until the trade is closed out. Risk is not separate from every trade. Risk can't be eliminated, but it can be minimized through proper money management.

See Also: Minimizing Risk In Forex Trading

In principle, money management addresses risk from trader's preferences of trading methodology and capital. In other words, you choose the most suitable money management strategy for you.

Just like picking a forex broker to invest your money in, ing a money management strategy that suits your trading style and amount of capital can be a confusing task as various strategies are available for your choosing. In any case, a good money management strategy must resolve the three questions below:

  • How many percent from the account balance may be allocated for a particular trade?
  • In case of a loss, how much capital can be invested to resume trading activities?
  • What degree of leverage should be used on a particular trade?

Each of these questions addresses the main objective of a proper money management strategy, which is to make use of available capital in an efficient manner to maintain longevity in the forex market. A good money management strategy maintains your trading methodology as a whole, which will enhance the possibility of success in any given trade.

 

Basic Money Management Strategies

For those who take forex trading seriously, maximizing profits with money management strategies is a normal practice. Money management strategies range from aggressive to conservative, depending on the trader's personal style. Aggressive strategies involve bigger leverage with the goal of big occasional profits. On the other hand, conservative traders are more reserved in their approach as their main goal is to preserve capital.

There are many guidelines for prudent money management. One of them is the concept of always trading using a positive risk to reward ratio. A risk to reward ratio is the potential returns traders can gain for the amount of capital risked. So a positive risk to reward ratio means that traders place more weight on prospective returns than potential losses.

In fact, it is possible to still make money even with a relatively low win rate if you use a positive risk to reward ratio. For example, you risk $200 with a risk to reward ratio of 1:2. From a total of ten trades, you win only four trades (+$1,600) while losing the remaining six (–$1,200). From these trades, you still generate a tot l profit of $400 ($1,600– $1,200) even though the win rate is only 40%.

See Also: How To Earn Consistent Profit From Forex Trading

On the contrary, a negative risk to reward ratio requires a high win rate to sustain profitability, which is a difficult thing to do. Now let's say your capital risk is $200 but with a risk to reward ratio of 2:1. You win six trades (+$600) and lose the other three (–$800). Even though the win rate is 60%, you actually lose a total of $200 ($600 – $800).

From the two examples, it is understandable why a positive risk to reward ratio is more popular among forex traders.

Money management calls for full commitment from the trader's part. It is a challenge on its own, and traders will be tested to remain consistent and loyal in applying proper money management, such as the concept of positive risk to reward ratio. Below, we will discuss three basic money management strategies that many traders have implemented.

 

1. Flat Risk Method

The flat risk method is the most basic money management strategy where traders risk a constant, predetermined portion of capital on any given trade. The risk values depend on the account capital, the currencies traded, the profit target, and the risk tolerance of the trader, though the most common is at 1-3% of the initial account balance per trade.

The flat risk method is most suitable for conservative traders, thus 3% is considered to be the most optimal percentage for the flat risk method. Let's imagine if aggressive traders employ the flat risk method with a high-risk value of 25%. It will only take them four losing trades in a row to blow up their account. Compare this to traders who are more conservative to approach the market and place a 2% risk instead. Even with four consecutive losses, they will still have 88% of their capital and a chance of turning things around.

The premise of this method is pretty simple. If the balance of your trading account is $30,000 and you set the risk at 3%, then the maximum risk of any given trade is $900. Regardless of the results of the trades you make, the risk value remains constant at 3% of the initial account balance. For example, if you lose the first trade, your capital will be reduced to $29,100. For the second trade, the risk remains $900 instead of 3% x $29,100 = $873.

See Also: Trading Journal: A Story of Making Profit with Small Capital

In the real market, however, it is pretty common for traders to tweak the flat risk method to suit their needs. One of the most commonly used variations is called compounding or reinvesting.

Simple compounding involves applying the predetermined risk value to the fluctuated account balance. As a result, traders can maximize profit targets when the account gets bigger, and minimize potential losses when the account gets smaller.

You probably have noticed by now that our previous example is applicable to this case. Using compounding, you take a risk of $873 instead of $900. Now suppose the first trade is a win with a risk to reward ratio of 1:2. Your capital will thus increase to $31,800. This means that for the second trade, you risk 3% of the increased capital of $31,800, which is $954.

Flat risk can also be adjusted to represent the amount of leverage imposed on the trading account at one time instead of per trade. Trading opportunities can arise at any time, and traders are likely to take the chance and place multiple trades at once. However, keep in mind that simultaneous, multiple trades also increase risk.

Using the $30,000 account and 3% risk value above as an example, three simultaneous trades will amount to a total risk of $900. If the risk value is adjusted to represent a 3% risk of the account balance at one time, the initial risk will remain at $900. This amount can be used for one trade or be spread among the three trades with necessary adjustments.

The flat risk method presents some advantages to traders. It can be applied to prevent disastrous loss. It also offers longevity for your trading career and reduces short-term variance in account value. As this method is by no means perfect, there are some disadvantages you should be aware of, such as the limitation on potential profits and the difficulty for recovery after traders continue to experience drawdown. Also, this method emphasizes the importance of setting the most proper risk value.

See Also: 17 Common Trading Mistakes That Result in Great Loss

 

2. Kelly Criterion

The "Kelly Criterion" is a mathematical formula developed by John Kelly while working at Bell Labs in 1956. The formula determines the percentage of capital to be risked on a trade based on the winning probability of a trade. Unlike the flat risk method, this strategy encourages traders to increase the risk if the winning probability is higher. For example, a trade with an 80% winning probability should be optimized with bigger capital compared to a trade with a smaller winning percentage, such as 10% or 20%.

Most trading platforms provide an automatic calculation for the Kelly Criterion, but it does not hurt to understand how the calculation works. There are two main variables of the formula, which are the winning probability and the win/loss ratio. Many complex variations of the Kelly criterion formula are implemented all over the world due to the use of the statistical approach. The simplest version commonly used by traders is:

Kelly % = W – [(1–W) / R]

where:

W = win percentage of trading system
R = average profit of winning trades / average loss of losing trades

For example, if the winning probability of a trade is 50%, the average profit is 6%, and the average loss is 3%, the calculation of the Kelly Criterion is as follows:

Kelly % = W – [(1–W) / R]

= 0.5 – [(1–0.5) / (0.06/0.03)]
= 0.5 – [0.5 / 2]
= 0.25 or 25%

In conclusion, based on the Kelly Criterion, the optimal amount of risk for the trade is no more than 25% of the trading account.

The benefits of using the Kelly Criterion are it offers large potential profits, limits the risk, and has the ability to maximize profits with a high winning probability. On the negative side, however, a high winning probability simultaneously increases the risk for a trade, which can be a disaster. Consecutive losses can also be catastrophic for the trading account. In addition, a large variance in account value can hinder the ability to sustain trading activities.

 

3. Martingale Strategy

The martingale strategy, a brainchild of French mathematician Paul Pierre Levy, has been around since the 18th century. It was originally a type of betting style but is subsequently adapted to trading management. The main premise of the Martingale strategy is to "double down" after a loss, with a risk to reward ratio set at 1:1, in the hope that it will only take one winning trade to cover all the losing trades.

However, traders need to inject a large amount of capital into their accounts. This is because successive losing streaks will eat up a substantial portion of the account. Suppose you want to trade a sum of $5 and your risk to reward ratio is 1:1. Let's say you lose $5 on the first trade, so for the second trade you double the capital to $10. If you end up suffering a sequence of losses, here is how much capital you need in your account:

  • 3 consecutive losses: $20
  • 5 consecutive losses: $160
  • 8 consecutive losses: $640
  • 10 consecutive losses: $2,560
  • 12 consecutive losses: $10,240

From the scenario above, we can see how a bet of $5 can lead to a risk of $160 from 5 losses in a row. If you only have $100 capital on your account, you will be forced to quit and lose all your capital.

See Also: 5 Key Tips on Money Management

That being said, the martingale strategy has been practiced for years in trading as it presents the opportunity of turnaround from a negative position to profitability. So how do we apply martingale successfully?

We place the price levels at the points at which we set our profit target and stop loss. This will enable us to have a risk to reward ratio of 1:1. Let's take a look at the trade performed on EUR/USD to better understand the application of the martingale strategy on forex trading:

  • On July 12, 2016, at 10:03 AM, we trade one lot of EUR/USD at 1.1095. The target is virtually set 30 pips below at 1.1065 and the stop 30 pips above at 1.1125.
  • Unfortunately, the market moves against our expected outcome, and at 10:15 AM our stop is triggered. However, the trade is not automatically closed out because we only use a virtual stop. Instead, we open a new trade to double the original trade size.
  • We enter a new position at 1.1125, also 1 lot, with the new virtual stop 30 pips above at 1.1155 and the new virtual target 30 pips below at 1.1095.
  • We replace the original target with the new one at 1.1095, which is used to exit both trades.
  • Since we originally sell 1 lot at 1.1095 and sell another lot at 1.1125, our average entry point is 1.1100.
  • This time, the price moves down and hit our new target. At 13:55 PM, we exit the trade at 1.1095 which is 15 pips below our average entry point.
  • The pip value for one lot of EUR/USD is $10, which gives us a total profit of 15 pips x $10 = $150.

Traders can take advantage of the martingale strategy in range-bound markets since the probability of success is higher. This strategy also improves the possibility of sustained profits in the short-run. The profit target is predetermined at a fixed sum of monetary value, so traders can keep tabs on their account capital.

As already mentioned above, however, the main drawback of this strategy is it requires a huge amount of capital. Likewise, the leverage required in order to double the risk can multiply quickly. And lastly, consecutive losses can ruin the account as risk grows exponentially for every losing trade.

See Also: Seven Don'ts Of Forex Trading To Avoid Losses

 

Summary

There are many factors that decide whether an open trade will result in profit or loss. Money management cannot guarantee trading results to be favorable to traders, but then again, nothing can. What money management does, however, is to optimize the effect of winning trades and to reduce the impact of losing trades.

The type of money management strategy that you exercise is dependent upon your personality and the overall scope of the trading activities. A more conservative strategy, such as the flat risk method, works well for conservative traders whose main concern is to protect the capital.

For traders who have big capital, money management strategies such as the Kelly Criterion or the Martingale strategy allow more aggressive trades. Regardless of which money management strategy you choose, make sure it is suitable for your preferred trading strategy and amount of capital, as well as your trading objective as a whole. For easier implementation, you can use the money management calculator.