Money Management 101

Introduction

It’s time to switch gears for a moment and begin to look at money management. In this chapter, we will cover the basic concepts behind money management. We will also cover the psychology behind money management. By the time you have finished this book, it should be clear how closely the two concepts are linked.

A clear understanding of money management is important. The way you manage your money will make or break you as a trader. You can have the best trading technique in the world – that one that wins 90% of the time – without proper management of your funds though, that other 10% of the time will likely erase your account!

I cannot stress how important managing your account is to success in Forex. If you don’t employ proper money management you shouldn’t expect to make money as a trader. You may accidentally turn a profit and even keep it there for a while. But without managing your money properly it’s just as likely that you will erase your entire account quickly.

What is Money Management and why do I need it?

Money management, as it suggests, is the way in which you manage the money in your Forex trading account. More than that though, it is the way that you minimize your risk and ensure that you maximize your profits.

Properly employed money management gives you the most important element of success in trading. The best trading system in the world won’t help you to profit if you aren’t managing your money. In any type of trading, there is an element of risk involved. With the large leverages available in Forex your risk can be quite high if you don’t properly manage risk.

The only way to properly manage risk is by creating a system that allows you to control how much of your own money is on the line. This is the simple part of money management.

Controlled risk = controlled losses.

It’s more than just minimizing losses though. Money management is also the way that you maximize your profits when you’re in on a winning trade. When you combine a system that controls risks with methods to maximize equity gains, what you end up with is that one element can take even a bad trading system and make it profitable.

Key Concepts in Money Management

Let’s begin our look at money management by looking at some key concepts and terminology. This will help you to gain clarity as we move into effective money management and the psychology behind choosing a system that works for you.

Compounding – A good money management system should take advantage of compounding. It allows you to take advantage of equity run-ups. In other words, as your account grows you compound your profits by taking advantage of that higher balance and trading larger lot sizes (within your defined risk level).

Leverage – Leverage is basically making use of credit. If you had a $100,000 account and never traded more than $100,000 your leverage would be 1:1. Many Forex brokers allow for leverages of 100:1 (or even higher in some cases). In other words, you can trade that same $100,000 with only $1000 in your account.

Your money management system needs to account for leverage to allow you to maximize the benefits of leverage while controlling the higher risk it exposes you to. Employing leverage obviously allows you to make much higher profits than you could without it, but it also exposes you to much higher risks. If combined with compounding schemes, such as pyramiding, leverage can actually be quite disastrous. A good system of management will allow for, and control the risk involved with high leverages.

Balance – The idea of balance is very important to proper money management. A good money management system will help you to find a balance between cutting losses and permitting losses. In some cases being too quick to cut your losses can lead to wasting a perfectly good opportunity.  If you destroy too many opportunities you greatly decrease your chance to profit. On the other hand, if you allow losses to run rampant – well, we don’t even need to say what that will lead to.

The idea of finding balance needs to be honed as well. It isn’t enough just to find your balance and keep it there. You should hone your system as you begin to learn how it performs. Gaining an extra two pips on a trade (for example) if you could do it consistently could add up to big money over the course of a year. Be sure to monitor how well-balanced your system is and adjust your stops accordingly.

Position Size – Position size, as the term suggests, is the amount of money that you have on the line in any given trade. A good money management system should account for position size, relative to your account size, and then employ stops to minimize your losses on trades.

Our own Tolerance and Emotional Control – A good money management system will account for and fit within our own risk tolerance. Even as we grow our account, and the tolerance increases, the system should be easily adjustable as your tolerance increase and decreases. Proper risk management, within our own tolerance level, is the best way to maintain emotional control. With our emotions in check, it is much less likely that we will make stupid decisions and get out of a trade too early.

Managing Risk – Finally, since our main purpose of money management is to minimize losses, a good system should manage the risk that you take on any given trade, on your whole account, and it should be calculated as a percentage that can be accounted for before entering any trade.

Considering Risk

Before we move on let’s talk further about the idea of risk. Your money management system doesn’t just need to define your risk tolerance for a single trade. The following areas should be understood and considered before making any trade.

Per Trade Risk – The amount of money you risk on any single trade.

As an example, if you went long on EUR/USD pair at 1.2000 with a stop of 1.1980 you are risking 20 pips (1.2000 – 1.1980 = 20 pips). Obviously that alone doesn’t tell us much so we calculate the risk into a percentage of our total account

With a position size of $100,000 we calculate:

1 pip = 1/10,000^th of a dollar

$100,000 X 0.0001 = $10 per pip x 20 pips = a risk of $200.

If you have an account balance of $10,000 then you are risking $200/$10,000 = .02 or 2% of your account.

Account Risk – The aggregate risk of all open trades.

This can be calculated by following the example above until you get to the $ risk per trade. Add all of the figures together and then divide that number by your account balance. This will give you the percentage risked on all open trades.

Percent Risk (%R) – This is the most commonly used method of proper money management. With this model of risk management, you simply select a percentage that you are willing to risk on any given trade and stick to that.

Some trading/money management systems use more than one “percent risk” figure. They may have an A-trade risk amount and a B-trade risk amount. In this case, the system would define which trades get the risk amount that correlates to the type of trade you are entering.

Using Money Management Effectively

Now that we know some of the key concepts let’s talk about how to apply money management to your trading effectively.

Let’s begin with some basic concepts for newer traders. When you’re just starting out, there is one basic idea that will help you to learn to succeed at trading without erasing your account in the process.

That concept is quite simple: Never open a position size that is greater than 1% of your account until you are more comfortable with trading.  By using the 1% rule you can lose 69 times in a row, without a single profitable trade, and still, only lose half of your account balance. If that still isn’t within your risk tolerance, start out at .5% per trade. With a ½% trade rule, you could lose 139 times before half of your account was gone.

There are some other rules you should follow before ever trading with real money (practice accounts are good for something). You need, at the very least, the following things in place before putting your own money on the line:

1. A trading system that you believe in. Preferably one that you have traded on a practice account and had success with. Your trading system should clearly define your entry and exit points for any given trade.
2. A money management system that fits within your own risk tolerance. The fits part is very important. If your money management system doesn’t fit your tolerance you’ll likely trade with your emotions, and end up losing.

Your money management system should define the following:

• Your Position Size
• Stops for Each Trade
• A Compounding Methodology.

With that said, let’s move on and talk more about position sizing, stops, and compounding.

Position Sizing with Stops

The most effective way to manage your money is by using the percent risk model and then applying it with the position size and stops. Let’s clarify this:

In our per trade risk example, we used a 20 pip stop and calculate that if we traded 1 lot ($100,000) of EUR/USD we were risking $200. ($100,000 X 0.0001 = $10 per pip x 20 pips = a risk of $200) To make it simple: For every 10-point stop on 1 lot of EUR/USD, we are risking $100.

If we had a 100k account, we would be risking 0.1% of that account if we opened a trade for 1 lot with a 10-point stop. With our 1% per trade rule you can risk $1000 on any given trade.

So it follows that: We could trade 10 lots with a 10-point stop. We could also trade 5 lots with a 20-point stop ($1000 total allow risk/$200 risk for a 20-point stop = 5 lots), or 3 lots with a 30-point stop (3.3 lots if your broker allows for partial lots). If we wanted a 40 pip stop we could trade 2 lots (again 2.5 if your broker allows partial lot trades).

Using this idea you can adjust your money management system to almost any trading system. If the system requires a ten-point stop, trade 10 lots. If you need a 20-point stop, trade 5. As long as you are only putting 1% of your account on the line, and using stops, you are enabling yourself to minimize your losses. Of course, those numbers should be adjusted as your risk tolerance increases and you find yourself okay at 2% per trade risk level.

Compounding Properly

The next part of your money management plan should include compounding. This concept isn’t really that difficult to understand. As you build equity in your account, you have more money to use in your trades (assuming you didn’t pull it all out), and in turn, you can trade higher amounts.

Where the problem comes in is that this is one area where many traders don’t follow their own rules and they suddenly end up throwing their whole money management plan out the window.

Let’s use a quick example:

1. You have an account with $100,000
2. If we were using a 10-point stop, we could then trade 10 lots to meet our 1% rule.
3. In a month’s, the time we earned $10,000 and grew our account to $110,000
4. Now we are able to trade 11 lots

The idea is quite simple, but there is a problem for some. Many traders start trading that extra lot too early and thus increase their risk exposure. An extra $100 of risk may not seem like a lot if your account is sitting at $106,000, but if you add that extra $100 to each of the 10 trades you make each week you’re suddenly risking $1,000 a week extra. This extra risk exposure can work to draw down your account quite quickly.

It is important to stick to your money management principles always. Those who don’t often find themselves forgetting the principles they started with and end up losing big.

The Psychology of Money Management

Likely the most overlooked aspect of money management is the psychology behind it. Remember back in chapter one, we said that we were all different (in that our mental and emotional makeup is unique). That simple idea isn’t often accounted for when it comes to managing funds for trading, and it really should be.

You don’t want to trade based off of emotions, and there are two main problem areas that cause many traders to do just that. Those areas are position size and trading systems. They both relate to the way we think and can cause problems for us if we become emotionally involved.

Position Size

The most important aspect of your money management plan, as it relates to psychology, is your position size. When you trade you’ll immediately discover how confident you are in that trade. Possibly the market could move a couple of hundred pips without greatly affecting your account; in which case your likely using the right position size. On the other hand, if you’re suddenly worried about your trade, it is very likely outside your emotional tolerance range.

If you’re making trades that are outside of your own emotional tolerance one thing tends to happen consistently: usually your emotions guide you to make stupid trading decisions. This may be entering a trade (or a number of trades) at the wrong time, or exiting too early and losing the profit that you could have taken. Whatever the case, as soon as your emotions are involved, your trading ability declines. You’ll tend to follow your own rules less often and you’ll make more mistakes.

Always ensure your position size and %R are within your own risk tolerance!

System Psychology

Another common problem for traders is the lack of a system or lack of confidence in the system they are using. This can lead to two problems:

1. You may find yourself trading based on emotions which will lead you to fail
2. It can lower your tolerance level, and then we go back to trading smaller position sizes or allowing our emotions to rule us.

Whenever you make trade decisions they should be based on a trading system with proper money management. That is, a system of rules that tells you when to enter the market, when to exit, and what amount to trade.  Using a trading system (that you have tested and are confident that will give you an edge) generally causes something else to happen, which we will call system psychology.

When you trade based off of systematic entry points and exit points you begin to see your trades as an aggregated group of trades rather than a single trade. This allows us to relate (emotionally) to the risk over time, and view each individual trade from a healthier emotional perspective. We relate better to individual losses and gains without panicking and making bad decisions based off of our emotions.

Lacking a decent system can cause you to compound your psychological problems when trading. You suddenly begin focusing on individual trades, and then we go right back the position sizing problem.

Always be sure to have a trading system that you can use confidently. Practice those systems on demo accounts to ensure that they work for you and to build confidence that the system gives you an edge.

Psychology of the Demo Account

One last thing I wanted to cover before I moved on is demo accounts. This really is one area where many traders have problems. They get out of their demo accounts too early and begin trading with real money.

There is a reason I left this section until now – when a trader does this, he usually ends up with both of the previous problems I mentioned, and they’re even more difficult to overcome.

When we fail at something, many of us learn to cope, move on, and in many cases we move past the emotions associated with failing. The problem is that we rarely regain the confidence required to excel at that task again. Even if we aren’t directly thinking about it, that failure sticks with us and causes even more unneeded fear.

When you apply this to trading here is what happens:

• A trader begins turning a profit with their demo account and quickly moves to real money (it stands to reason they should be making money for themselves right?)
• That trader hasn’t grown confident in a trading system, they don’t know how to manage their risk, and there tolerance when using real money is much lower than it was in the demo trading environment.
• They suddenly find themselves anxious whenever they make a trade, and they end up becoming ruled by their emotions.
• They fail – trading based on emotion alone is simply a bad idea.

That trader has just gone through the first two psychological problems we discussed, but they have created another one for themselves. Even if they do recover and start trading again, that first failure will always stick with them. It isn’t very likely that they will ever excel at Forex because they suddenly have an extra degree of fear associated with trading. Nobody likes to fail, so don’t set yourself up to do just that!