Money management is one of the most important elements that show difference between winners and losers. It was proved that if 100 traders start trading using a system with 60% winning odds, only 5 traders will be in profit at the end of the year. In spite of the 60% winning odds 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 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 your going to take for this trade.
There are different money management strategies. They all designate for preserving your balance from high risk exposure purpose.
First of all, you should understand the following term Core equity
Core equity = Starting balance – Amount in open positions.
If you have a balance of 10,000$ and you enter a trade with 1,000$ then your core equity is 9,000$. If you enter another 1,000$ trade,your core equity will be 8,000$.
It’s important to understand what’s meant by core equity since your money management will depend on this equity.
We will explain here one model of money management that has proved high anual return with limited risk. The standard account that we will be discussing is 100,000$ account with 20:1 leverage . Anyway, you can adjust this strategy to fit smaller or bigger trading accounts.
Money management strategy
You should never take more than 3% risk per trade. It’s better to adjust your risk to 1% or 2%
We prefer a risk of 1% but if you are confident in your trading system then you can lever your risk up to 3%.
1% risk of a 100,000$ account = 1,000$
You should adjust your stop loss so that you will never lose more than 1,000$ per a single trade.
If you are a short-term trader and you put your stop loss at 50 pips below/above your entry point .
50 pips = 1,000$
1 pips = 20$
The size of your trade should be adjusted so that you risk is 20$/pip. With 20:1 leverage, your trade size will be 200,000$.
If the trade is stopped, you will lose 1,000$, 1% of your balance.
This trade will require 10,000$ = 10% of your balance.
If you are a long-term trader and you put your stop loss at 200 pips below/above your entry point.
200 pips = 1,000$
1 pip = 5$
The size of your trade should be adjusted so that you risk is 5$/pip. With 20:1 leverage, your trade size will be 50,000$.
If the trade is stopped, you will lose 1,000$, 1% of your balance.
This trade will require 2,500$ = 2.5% of your balance.
This’s just an example. It will be difference from this formula by your trading balance and leverage provided by your broker. The most important is to stick to the 1% risk rule. Never take too much risk in one trade. It’s a fatal mistake when a trader lose 2 or 3 trades in a row, then he or she will be confident that his next trade will be winning and he may take more risk to this trade. This’s how you can blow up your account in a short time! A disciplined trader should never let his emotions and greed control his decisions.
Trading one currnecy pair will generate few trading signals. It would be better to diversify your trades between several currencies. If you have 100,000$ balance and you have taken position with 10,000$ then your core equity is 90,000$. If you want to take second position then you should calculate 1% risk of your core equity not of your starting balance! It means that the second trade risk should never be more than 900$. If you want to enter 3rd position and your core equity is 80,000$ then the risk per 3rd trade should not be more than 800$.
It is important that you diversify your prders between currencies that have low correlation. For example, If you have a long position of EUR/USD then you shouldn’t take long positions of GBP/USD since they have high correlation. If you have long EUR/USD and GBP/USD positions and risking 3% per trade then your risk is 6% since the trades will tend to end in same direction.
If you really want to trade both EUR/USD and GBP/USD and your standard position size from your money management is 10,000$ (1% risk rule) then you can trade 5,000$ EUR/USD and 5,000$ GBP/USD. In this way,you will be risking 0.5% on each position.
The Martingale and anti-martingale strategy
It’s very important to understand these 2 strategies.
-Martingale rule = increasing your risk when losing !
This’s a startegy adopted by gamblers which claims that you should increase the size of your trades when losing. It’s applied in gambling in the following way. Bet 10$, if you lose bet 20$, if you lose bet 40$, if you lose bet 80$, if you lose bet 160$..etc
This strategy assumes that after 4 or 5 losing trades, your chance to win is bigger. So you should add more money to recover your loss! The truth is that the odds are same in spite of your previous loss! If you have 5 losses in a row, still your odds for 6th bet 50:50! The same fatal mistake can be made by some new traders. For example, if a trader started trading with a abalance of 10,000$ and after 4 losing trades (each is 1,000$) his balance is 6000$. The trader will think that he has higher chances of winning the 5th trade then he will increase ths size of his position 4 times to recover his loss. If he lose, his balance will be 2,000$!! He will never recover from 2,000$ to his startiing balance 10,000$. A disciplined trader should never use such gambling method unless he wants to lose his money in a short time.
-Anti-martingale rule = increase your risk when winning & decrease your risk when losing
This means that the trader should adjust the size of his positions according to his new gains or losses. Example: Trader A starts with a balance of 10,000$. His standard trade size is 1,000$
After 2 weeks, his balance is 15,000$. He should adjust his trade size to 1,500$. Trader B starts with 10,000$.His standard trade size is 1,000$. After two weeks his balance is 8,000$. He should adjust his trade size to 800$.
High return strategy
This strategy is for traders who look for higher return and still preserving their starting balance.
According to your money management rules, you should be risking 1% of you balance. If you start with 10,000$ and your trade size is 1,000$ (Risk 1%). After 6 months, your balance is 15,000$. Now you have your initial balance + 5,000$ profit. You can increase your potential profit by risking more from this profit while restricting your initial balance risk to 1%. For example,you can calcualte your trade in the following pattern:
1% risk 10,000$ (initial balance)+ 5% of 5,000$ (profit)
In this way, you will have more potential for higher returns and on the same time you are still risking 1% of your initial deposit.
Money management is the most important part of any trading system, adjust your strategy to become a winner. Good luck.