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Money Management

If you do not have a 100% winning strategy, money management should be the most important part of your FOREX trading system. If you have good money management, you can trade even based on coin toss.

The main point of money management is to controll the risk, and this way control your losses and also your gains. The best way to explain the basics of money management is to use examples. When you open a position there are three posibilites:
  • 1. you close your position with gain
  • 2. you close your position with loss
  • 3. you close it in 0, with no gain and no loss
What do you think, how will it affect your capital if you close 50% of your positions with gain and 50% of your positions with loss? Here are three posibilities again:
  • 1. you will have as much money as you had in the beginning
  • 2. you will have less money
  • 3. you will have more money
What will happen, depends on your money management! Lets make some calculations and suppose that you have 1000 USD as initial deposit, you trade on 1:100 leverage, and you will close 10 positions, 50% of your positions in gain and 50% of your positions in loss. Now, lets see three examples with three different money management.
  • 1. your gain on one position is always 100 USD, your loss on one position is always 100 USD
  • 2. your gain on one position is always 100 USD, your loss on one position is always 50 USD
  • 3. your gain on one position is always 50 USD, your loss on one position is always 100 USD
1. example 2. example 3. example
intial capital
1000 1000 1000
1.trade
-100 -50 -100
2.trade
-100 -50 -100
3.trade
-100 -50 -100
4.trade
-100 -50 -100
5.trade
-100 -50 -100
6.trade
100 100 50
7.trade
100 100 50
8.trade
100 100 50
9.trade
100 100 50
10.trade
100 100 50
total
1000 1250 750

On the table above you can see the results of three different money management, but we haven't yet talked about the position size and the order of gains and losses. If we focus on the order of gains and losses all the three scenarios seem to be very pessimistic, but it could happen. In the 1. and 3. example, after a 5. trade the 50% of the initial capital is lost. This is a very difficult situation, because in order to get back the other 50% of your initial deposit, you need to make a gain of 100% on your actual capital. (1000*50%=500, 500*100%=500).

You can see that the 2. scenario is much better. After the 5. trade only 25% of your initial deposit is gone. Your actual capital is 750 USD, so you need to make only 250 USD to get back your initial capital, which is only 33.33% of the 750 USD. It is much easier to gain 33,33% than 100%, right?

Now, lets talk about the position size.

If we trade on 1:100 leverage with a 100 USD position, one pip will be about 1 USD. That means that you need to make 100 pips to have 100 USD gain or loss.
  • position size 1000 USD: 10 pips = 100 USD
  • position size 100 USD: 100 pips = 100 USD
  • position size 10 USD: 1000 pips = 100 USD
What does this mean? Trading with bigger position size, you need to make less pips to get your 100 USD profit, but you also need to set your stop loss thighter. If we agree that the 2. scenario is better than the 1. and the 3., the maximum loss we support on one position will be 50 USD. So:
  • if the position size is 1000 USD, we need to use a 5 pips stop loss, wich is not a good idea, because that stop will be hit almost immediately
  • if the position size is 100 USD, we need to use a 50 pips stop loss, which is much better than 5 pips
  • if the position size is 10 USD, we need to use a 500 pips stop loss, which supports much bigger moves, but you also need to use a 1000 pips target to get your 100 USD profit
One of the basic money management rule is, to risk only 1-2% of your capital in on trade. Most people misunderstand this. They think that they need to use 1-2% as position size. This is wrong. The measure of the risk in one positions depends on the stop loss. So, lets see how can we risk only 1% of our capital in one position if our margin is 1000 USD. Simple, our stop loss must be 10 USD, and we use different position sizes:
  • if the position size is 1000 USD, 10 USD is 1 pip
  • if the position size is 100 USD, 10 USD is 10 pips
  • if the position size is 10 USD, 10 USD is 100 pips

Risking only 1% of your initial deposit on every trade, means that you need to lose 50 positions to lose 50% of your capital, or 100 to lose 100%. If you risk 2%, after 25 positions closed in loss, it will take the 50% of your capital.

If you risk more than 1-2%, always try to use a position size and a stop loss that allows you to use the same position size each time, lets see an example:

Lets say your capital is 1000 USD, and you risk 100 USD on every position, you can lose 10 trades. If you open a position with 1000 USD and lose the 100 USD, next time you will be forced to open a smaller position with maximum 900 USD. If you lose 100 USD again, next time the maximum position size you can use will be only 800. On the 1000 USD you will lose 100 USD with a 10 pip stop loss, but, if in the end the maximum position that you can open is 500 USD, you need to make 20 pips to get back the 100 USD... So, if you are forced to open a smaller position each time, you need to make more and more pips to recover what you lost with the bigger position.

There is no general money management that can be used by anyone. Each trader needs to develop his/her own money management taking into cosideration his/her trading style, trading strategy, the number of positions opened a month, risk level accepted and so on.

The most important is to understand, that if you do not have a 100% winning strategy, you need money management. You need to accept that some of your positions will be closed with loss. So, you need to decide what is the maximum loss that you will handle, and what is the minimum profit you want to gain on one trade. Remember: money management will work only if you let stop loss and exit target work.

 

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Please note!
Trading foreign exchange (FOREX) on margin carries a high level of risk, and may not be suitable for all investors. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. You should not invest money that you cannot afford to lose.