Money Management
Like all aspects of trading there are no hard and fast money management rules. Money management can simply be defined as ‘how much capital to risk?’ and ‘how many contracts to trade?’. This is one of the most crucial concerns a trader faces; it determines your risk and profit and is often a technique neglected by traders. One of the keys to trading success is lasting in the game and not over committing your account to any single position.
The belief is that the markets will reward us with profits in due course and that we cannot force profits from the markets in the interim. You cannot predict the future, merely enable yourself to align with the current `line of least resistance’ and therefore increase the overall probability of success. As a trader your primary role is preserving your trading account equity so that you will trade larger, longer and more profitably.
Losing trades are inevitable to any trading plan and it’s the ability to manage these losing periods and preserve capital that will enable long-term survival and capital appreciation. Sound money management philosophy and skills are absolutely fundamental to success to keep losses small. Successful foreign exchange traders work according to probabilities, aiming to win on average more than they lose. Whatever the approach, money management reduces the need to find the perfect system. Following are a number of very basics rules to help you get started:
– Trade only what you can afford to lose
Foreign exchange trading is risky, so do not fund your trading with core finances – that is, money which if lost could place you into financial difficulty ie. Credit cards, personal loans, overdrafts etc.
– Failure to use stop loss orders
With so much written about the merits of stop loss orders it seems inconceivable that some traders still refuse to use them. By using a stop loss, a trader attempts to set limits as to their maximum drawdown from a trade. When a stop is triggered, this tells the trader that their original market view was incorrect and it is now time cut their losses and enter the market another time. Traders who do not use stops are destined to turn small losses into large ones. In turn, this breaches their trading plan and forsakes the money management rules so critical for long term success. When setting stop loss orders or trading through the stop level (market gaps) the impact of slippage also needs to be considered (ie the possible cost in terms of the bid/ask spread that may have to be paid to exit a position).
– Place intelligent ‘stop loss’ orders
It is essential to use stops to ensure losses are limited in the event the market moves against you. However avoid setting them at fixed amounts, either too close to the current price or on obvious support and resistance levels. Know the average daily movement of contracts that you are trading as this may help you set your stop loss points (eg. AUD has an average daily range of 50 points).
– Large loss of capital
If your account equity declines by 50% at any stage, trading should be halted immediately and indefinitely until you reassess your trading goals. Is Margin Foreign Exchange trading for you? It is imperative to keep your individual losses small. The table below shows you the returns you will need to generate based on the loss of your original capital. If you lose 50% you need to make 100% return just to break even – a very difficult task.
– Diversification
Diversification is the key to any trading plan. Look at a number of markets with one program or have a number of different programs for one market allowing for increased versatility in varying market conditions. It is well documented that dividing capital among unrelated markets can reduce risk. For example Program A, may only provide signals in a certain market type, whereas Program B may provide signals in other market types. Strict control of trading capital is possible with the application of basic common sense principles.
Questions to ask yourself are:
- What are my trading goals?
- How much money am I prepared to risk on individual trades and how much overall equity will be on the line?
- How and where will I set stop loss orders?
- What is an acceptable risk / reward ratio?
- What markets will I trade to diversify my portfolio?
Recommended Reading
Mathematics of Money Management, by Ralph Vince
New Commodity Trading Systems Methods, by Perry Kaufman
Technical Analysis of Stocks, Options and Foreign exchange, by William F Eng
