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Thursday, February 11, 2010

Holy Grail - Money Mangement

Money Management. Trade safe building stable gains

Money management is a way traders control their money flow: in or out of pockets... Yes, it's simply the knowledge and skills on managing a personal Forex account.

There are several rules of good money management:

1. Risk only small percentage of total account

Why is it so important? The main idea of the whole trading process is to survive! Survival first, and only then making money on top.

One should clearly understand, that Big traders first of all are skillful survivors. In addition, they usually have deep pockets, which means that under unfavorable conditions they are financially able to sustain big losses and continue trading. For the ordinary traders, the majority of us, the skills of surviving become a vital "must know" platform to keep trading accounts alive and, of course, to make good stable profits.

Let's take a look at the example that shows a difference between risking a small percentage of capital and risking a bigger one. In the worst case scenario of ten losing trades in a row the balance of trader's account will suffer this much:

Trades Account balanceRisking 2%
of total account per trade
1 Start — 5000 100
2 4900 98
3 4802 96
4 4706 94
5 4612 92
6 4520 90
7 4430 89
8 4341 87
9 4254 85
10 4169 — 17% of the account has been lost

Trades Account balanceRisking 10%
of total account per trade
1 Start — 5000 500
2 4500 450
3 4050 405
4 3645 364
5 3281 328
6 2953 295
7 2658 265
8 2392 239
9 2153 215
10 1938 — over 60% of the account has been lost

Apparently, there is a big difference between risking 2% and 10% of the total account per trade. A trader who has made 10 trades risking only 2% of balance per trade, under the worst conditions would lose only 17% of the total account. The same trader who had been exposing 10% of balance.

2. Rebuilding of a shrinking account is harder that it may seem to be

Let's take a look at calculations where a trader has lost some part of his account. How much effort will it take to recover the original account balance?

Account% of account lost New balance Need to make
$ 500025%$ 375035% of the new balance ($ 1250) to cover losses
$ 500050% $ 2500100% of the new balance ($ 2500) to cover losses
$ 500075%$ 1250300% of the new balance ($ 3750) to cover losses
Note that it's only to cover losses: Who is going to make money then..? And when?

Now, there is a challenge: try on your demo account to rise up 300% or at least 100% of your original account trading as it would be real money. Will that be easy? I don't think so. Can you prove me wrong?

3. Calculate risk / reward ratio before entering a trade

When chances to win in a trade are smaller than potential losses, don't trade! Remember — staying aside is a position.
For example: 40 pips to lose versus 30 pips to win, 20 pips to lose versus 20 pips to win — all that is a clear sign of bad risk management.
Before entering each trade, reassure that risk / reward ratio is at least 1:3, which means that chances to lose are tree times less than promises to win. For example: 30 pips of possible loss versus 100 pips of potential win is a good trade to consider entering.
Adopting this money management rule as a must, in the long run will dramatically increase trader's chances to succeed in making stable gains.
Next chart shows the "risk / reward" rule in practice. Ten trades based on 1:3 risk / reward ratio were conducted. A trader was losing only $ 100 in each trade when he was wrong, but won $ 300 in each profitable trade.

TradesLosing tradesWinning trades
Total- $500+ $1500
Grand Total+ $1000 in profit

As we can see, constantly using 1:3 risk / reward ratio and being successful only 50% of the time, trader will still make a profit. The higher the reward ratio ( compared to risk ratio ) the better are chances to end up in profit.

4. Learn to use protective stops

About protective stops and their importance for good money management continue reading: Learn to use Stop Loss effectively.

5. And now let's study the example of applying money management rules:

So, risking no more than 2-3% of the total account per trade... How does it work in practice? Let's use an example to understand this idea completely.

We have opened a trading account of 1000 dollars with a broker and got 20:1 leverage. So, now we have 20 000 dollars to trade with.

More "money" — more trading opportunities. Correct. But, more trading opportunities also means more risks, and when we talk about risks we talk about real account value which will shrink with each losing trade. So, when we say risking no more than 2-3% of total account value we mean real account value — which is 1000 dollars in our case.

Well, let's start trading and do the math. For our example, we have decided to always risk 2% of the account in each trade. 1000 x 2% = 20 dollars. So, when the price goes against us, we will be out of the trade once we are -20 dollars.

One note before we move on. To make our next calculations simple we will use simple values which can be different in the case with your broker.

Ok, time to trade and our trading potential measures 20 000 dollars ( thanks to our leverage ) .

Let's try to trade them all at once: for one 20 000 dollar order our broker gives us a pip value of 2 dollars. This means that with each pip gained we will have +2 dollars in our pockets.


1 comment:

Blogger said...

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