Mastering Money Management
Most beginning traders believe that a good entry into the market is the key to success. Unfortunately, most beginning traders are wrong. Money management is by far the most important criteria of trading, whether it's stocks, futures or FOREX. Every successful trader will agree that managing your trades correctly is the #1 key to consistent profits.
Losing a trade or several trades in a row is part of trading, period! Markets move in unpredictable ways and even the best programs and trading methodologies are not always right. In fact, most professional money managers trade with systems that are right only 50 percent of the time.
Now, I know many of you are thinking, "How can they make the huge returns they claim if they are only profitable 50 percent of the time"? It's simple, money management! If you're able to effectively manage your money, you only need to be right about 50 percent of the time. Unfortunately, 90 percent of today's traders primarily focus is making money not protecting what they have.
You have a 50/50 chance of the market going your way by flipping a coin. Let's say you flip a coin, heads you buy and tails you sell. Once you make your entry into the market you must protect your position in the event your flip of the coin goes against you. Let's discuss how this applies to the FOREX market and, in fact, any financial market.
Let's say for every $1,000 we use to control a position, we are only willing to loose $200. Now assume that for every trade you enter you expect to make at least twice what you're willing to loose. In the event your position goes your way, you would set a limit order for $400. We'll assume you made a total of 10 trades, 5 winners and 5 losers.
Sample Trade log. (Hypothetical of course)
Buy USD / JPY ($200.00)
Sell GBP/USD ($200.00)
Buy USD/CHF +$400.00
Sell EUR/USD ($200.00)
Sell USD/JPY +400.00
Buy EUR/USD +400.00
Buy USD/CHF +400.00
Sell GBP/USD ($200.00)
Buy USD/JPY ($200.00)
Sell EUR/USD +$400.00
Net Profits $1,000.00
Can you start to see what we are talking about? In the example, we have 50/50 trades but because we exercise good money managements by cutting our losses quickly and letting the gains look longer, we made money on the overall series of trades. Clearly the example shows the importance of following the rules associated with managing your trades for consistent profits. Setting a stop loss to protect your account is the first rule to staying in the trading game. Each time you enter a trade have your stop loss point already set in your head and immediately set it on your trading screen.
7 Golden Rules for effective Money Management.
RULE #1 NEVER, EVER, EVER TRADE WITHOUT A STOP LOSS.
Using a stop loss is only part of your money management strategy, but it is a very important part. A stop loss is a form of insurance that you'll be able to continue to play the game in the event you're wrong. It's insurance for the trader.
Rule #2 Always trade with a Risk Reward Ratio of 1 ½ to 1 or better on every trade.
Placing a stop loss is, of course, very important, but placing a proper stop loss is even more important. By this I mean, always be aware of your risk reward ratio. If you want to make $400, but are only willing to risk $200, then your risk reward ratio is 2 to 1.
Let's say you want to be even more conservative and trade only a 1 ½ to 1 risk reward ratio. In the example above you would have only netted $500, but you still netted $500! On a $10,000 account that is 5 percent of your balance. Ten trades in FOREX could simply be 1 trade per day Monday through Friday for 2 weeks.
Rule #3 Never over leverage your account.
Leverage is another key to making money in the FOREX. No other market in the world allows the leverage this incredible market offers. A 100 to one leverage is the normal fee that most FOREX brokerages allow investors to trade with. For example, each $1,000 you put up allows you to control $100,000 worth of currency! Think about that for a moment, it's really incredible! That's like them lending you $99,000.
This huge leverage allows us to make the huge returns the FOREX is known for. But, it also enables us to loose some or all of our money if we trade foolishly. Leverage is a wonderful money making tool, but when abused it can lead to financial destruction. Think about consumer credit cards for example.
The bank lets you borrow large sums of money on your word that you'll pay it back, but when credit is abused, it can lead to bankruptcy. So just like managing your credit debt you need to manage your trading leverage. Most people would not go out and rack up huge debt they knew they could not pay because it would not be responsible, right? Well, when trading the FOREX if you started with a $10,000 account should you start by trading 10 lots (using the full $10,000)? No, that would be foolish.
A very conservative yet effective method of trading is to never leverage more than 10 percent of your FOREX account on any one trade. So, with $10,000 you should realistically only trade one lot. In the example above, you could quickly grow your account in a relatively short amount of time. The compounding factor is powerful, due to most people's desire to get rich quick and take unnecessary risks. These traders tend to focus more on the dollar signs than on proper trading principles. If you truly want to make consistent profits and exceptional returns on your hard earned money, take it from someone who's been there; follow these simple but effective money management rules.
A good rule of thumb is to keep your leverage at 10 percent or less. More aggressive traders will trade with as high as 20 percent, but be sure you have the money to play. If you start with a mini account, start by trading only one position of a tenth of a lot. You're won't make huge money, as the position sizes are only one-tenth of a normal account but the percentage of returns will quickly allow you to start trading larger sums of money and in the end will allow you the success you seek.
Rule #4 Accept your losses, move onto the next trade and trust the software.
Emotions and money don't mix. Simply treat each trade as a business transaction and don't get emotionally attached. Take your losses and move on. Learning how to lose is more important than winning. Why, because a new trader will typically take their first loss, wonder what they did wrong and then sit on the side-lines and let profitable trades slip by. Discipline is another key factor in trading that tends to be a learned trait that takes a bit of time to get used too. So, accept your losses and move on.
Rule #5 Make realistic goals that can be achieved within reason.
Don't expect to make a living trading right from the start. There is a learning process every trader must go through to become successful. New traders need to not only learn to enter and exit trades correctly, but also the process of controlling your emotions. Many traders make ridiculous monetary goals when they start trading. Make a simple goal to get started. If you make a plan and stick to it, your rewards will surprise you.
Rule #6 Protect your profits when your position is profitable.
If you're a long-term trader such as a swing trader or position trader, it is important to protect your profits by using a trailing stop loss. For example, let's say you take a long position (buying) in the USD/JPY and you're looking for a return larger than $400. Now let's say your goal is $800 rather than $400 and you're currently sitting at a $500 profit.
Most professional traders would take this opportunity to trail their stop loss to at least an even position, or better yet, lock in a portion of these profits so you now have no chance of taking a loss. But remember, your goal was $800 or a loss of let's say $400, a 2 to 1 risk reward ratio. Now let's assume the market, for whatever reason, starts making a large move against your position. If you protected at least a portion of the trade or moved your stop to break even position, then you would avoided at least one loss that you were not willing to risk in the first place.
Rule #7 Always trade with money you can afford to lose.
Trading with money you cannot afford to lose is foolish, yet common among beginning traders. When trading, be sure to only trade with money that will not affect your lifestyle. You're trying to improve your lifestyle, not hamper it. When a trader trades with money they can afford to lose, they tend to be more focused and more disciplined because they are not worried about any single loss. They look forward to the overall return. Don't borrow money to trade on. Don't use your life savings. And, don't use the money that you would typically use to pay your monthly bills. This is the road to disaster. These types of traders have the same mentality that gamblers have. Remember, traders are not gamblers.
The hypothetical examples made above are in no way, meant to imply, assume or guarantee that any client will attain or even profit in the FOREX Market. These are hypothetical examples only. All markets have inherent risk, individual results may vary and unique experiences will differ.
Originally published in James Dicks: Buy*Sell*Hold magazine.