Before I move on from money management I wanted to take some time to cover some very common money management mistakes. There are two major mistakes that traders make as they are learning Forex and if you are guilty of either of these it will likely end your trading career early.
Whenever you trade, your money management principles should be applied to those trades, and you shouldn’t deviate from that plan. As you grow as a trader you’ll likely grow your risk tolerance and increase your risk on any given trade, but even then you should use a money management plan.
Money management ties in so much with trading psychology that by not using it or by not using your own system will ensure you fail!
Here is the most common money management mistake: not using it! Money management principles (including: compounding, risk taken, and stops) should be clearly defined right from the beginning of your trading career.
Your money management plan should be used right from your first demo account, through to your $500,000 equity account that you started 5 years ago with just $10,000.
The problem for some is that they hear the term “money management” and then think they have to earn some money to manage before getting started. Others tend to begin with money management but never really apply it, or apply it in a haphazard way.
Even more common is the trader that spends hours and hours learning their trading system. After all it’s the trading system that will tell you whether you win or lose. They focus so much on the system that they don’t bother to apply any type of risk management.
When you don’t employ proper management principles here is what ends up happening:
- A trader sits staring at their screen watching their charts. Waiting for the trade signal that their system gives them.
- Upon seeing the signal they waited for, they enter the trade.
- Without really planning what to risk, they haphazardly guess at how large of trade to take. They don’t have a money management plan, so no risk percent, or compounding rules are employed.
- They take the trade too large, hoping to maximize the profit, and they risk 5-10% of their account.
If you’ve been around trading for long, then you already know what will happen to this trader. Possibly they will win a few trades, but it won’t be long before they hit that 5 loss streak and erase half of their account. Since most of us can’t stomach losing that much money that quickly the trader will end up getting emotional about his account and will likely lose the other half as well.
With a management plan in place the whole situation is avoided. Really employing a risk management and compounding strategy is what separates the passionate trader (the one who will succeed) from the lazy trader who was looking to get rich quick.
Another common problem comes with the trader who decides to use someone else’s system to manage their own account. To clarify this one, let’s use an example:
For this example we have two traders: we have Rick who has been trading for 20 years, and has grown quite rich trading. We then Bob, who after seeing Rick’s success begins employing the trading system that has made Rick so much money! Bob has only been trading for a year, and thus far has only seen moderate success.
It doesn’t really matter at this point what trading system Bob is using, or how he got it. Possibly he purchased the plan from the Internet or maybe he just knows Rick. All that matters to us at this point is the money management principles included with it.
The system suggests using a 3% per trade risk model. It explains proper compounding and teaches Bob how to calculate trade size to match his 3% per trade rule.
Thinking that he has finally found the answer to his prayers, Bob begins using this system and the money management plan that Rick suggests!
In all likelihood Bob is about to have a rude awakening. There are some major problems with what he is about to do:
- The Risk Model doesn’t Fit with Bob’s Risk Tolerance
- He begins trading the system and quickly finds himself extremely worried after every trade
- This worry leads Bob to allow his emotions to rule him, and he constantly uses the wrong exits.
- He makes less profit on the good trades, exits trades that could have been profitable too early, and in turn after only a month his equity is cut in half.
When you think about it, Rick had 20 years experience as a trader. He also had big account equity and a much higher tolerance for risk. That 10 run losing streak doesn’t affect Rick. With 20 years as a trader he knows it will turn around and he will come out on top. He has confidence in his system and his money management plan fits his own trading psychology.
On the other hand Bob is the polar opposite. He’s new to trading so every losing trade gets him worried. He never really tested the system; he just took someone else’s word that it worked. Also his risk tolerance doesn’t allow for 3% per trade. With that amount of risk he could cut his account in half with only 20 trades.
Even if he did use Ricks trading system (there’s no reason why he shouldn’t), using a 1% risk model, or a 0.5% risk model would have made the losses easier to stomach, and in turn would have let him to learn to trust the trading system rather than fight it.
The simple fact is that YOUR money management plan needs to be designed for YOU. You know your own acceptable risk, and you know how each trade affects you. Using someone else’s system to manage YOUR money can be financial suicide!
To finish this chapter, I wanted to leave on a more positive note. We talked about some things you shouldn’t do. To finish it off, let’s recap the last few chapters and talk about what you should.
- You are going to design a money management plan that fits with your trading psychology. Your plan should define:
- A %-risk that is acceptable to you for every trade.
- Stop levels that fit with your trading system.
- Compounding (the example in the beginning of the last chapter shows the right way to do it).
- You are going to apply that money management plan to your trading system. Your trading system defines:
- Entry Points for a Trade
- Exit Points for a Trade
- You are going to be aware of Asymmetrical Leveraging so that when it does feel like you’re stuck you are less likely to get emotional about it.
- You are going to use your trading system and money management plan religiously for each and every trade.
The reality is that if you follow those four steps you are half way to success. To complete the picture let’s move back into trading psychology, and then we’ll finish the book by bring it all together.