What have trading and slicing up birthday cakes got in common?
Did you know there are only two key phases to ANY profitable trading approach?
Money management is simple enough to get right, but oh-so-easy to neglect in the heat of the moment. You’ll need to keep your self-discipline under control in order to apply this properly, but here are those two phases of money management that can make all the difference:
Phase 1: Survive
Phase 2: Prosper
Now phase one might sound a bit dreary… ‘Survive? I thought trading was all about making a small fortune!’
Well your fortune can come when the time is right. But you have to keep yourself in the game first. You need to keep your head above water!
First priority: Making sure you live to fight another day
The first phase of money management is all about protecting your trading capital.
Consistent profits will come from a random pattern of winning trades and losing trades. But you never quite know what the market will serve up next – will it be a profit or will it be a losing trade?
When you’ve got a proven system in place you’ll have a good idea of its performance over a larger number of trades. As an example, you might expect to win on, say, 55% of your trades. And when you win, you might make twice the money you give back on an average losing trade. That’s a very solid system.
And over a sample size of say 1,000 trades, you should see the overall win-to-loss ratio pretty close to 55% wins against 45% losses. But the smaller the sample size is, the more of a skewed effect the random distribution of winning and losing will have.
It means if you took a smaller sample batch of say 100 trades from your original 1,000, you might see a slightly skewed result. From that 100 trades you might find 72% were winners and 28% were losers, even though things eventually evened themselves out to 55%:45% across the full 1000 trades.
And what if we go smaller still…
Say we took a sample of 5 trades: with a 55% winning strike rate it would be perfectly possible to take 5 losing trades one after the other. All of them could have lost money. And it’s absolutely nothing to worry about!
Remember you make twice as much on winning trades as you give back on the losers, so it was just a short-term loan you made to the market. You’ll soon be back in front if you keep yourself in the game!
So, can you see where the problem might lie?
It all comes down to the way you divide-up your overall trading account. It’s all about the size of each account ‘slice’ that you allocate, and risk against each individual trade.
Now let’s say on that sample of 5 trades you had risked just 1% of your starting account size. As the fifth losing trade came to a close your self-discipline would certainly be tested, you’d need to keep your frustration under control, but you’d only be down 5% on your overall account. You could cover all those losses and be back in front within the next 3 trades.
But what if you’d gone at it a bit gung-ho…
Say you’d risked 20% of your starting account on each trade. Even though your system is a real top-drawer performer, you’d have blown yourself up!
Your entire account would have been wiped out by those 5 losing trades.
So can you see what a huge effect bad money management can have on your net results?
In fact, did you know that if you deplete your account by 20% (it’s called a 20% ‘drawdown’ in trader’s lingo) you’d need to show a 25% return on what was left, just to get back to break even?
And if you took a 50% drawdown you’d need to make a 100% return just to get back to your starting bank!
Trust me, it pays to strictly limit your exposure on each individual trade and let the law of averages deliver your profits across the long run.
So good money management is all about limiting the risk on each trade – you don’t want any single trade to have the potential to wreak havoc on your funds.
There’s a bit of an art to it: you obviously want to maximise the amount of money your system can make without risking a disastrous drawdown, but you just need to find the sweet spot for your own particular way of trading.
And don’t worry. It’s easy to do with a simple bit of maths…
Using Position Sizing to prosper from your trades
(This is where Phase 2 – prospering – comes into the equation. You’ll see how in a moment. The secret to achieving smooth growth in your account equity is to standardise the position size you take on each trade.
Now it’s no use staking a flat stake per pip on every single trade, because they’ll all have a different initial stop-loss size and therefore a different amount of initial exposure. (Imagine cutting up a birthday cake but giving each person at the party wildly differing sizes – a big fat slice for some people and a wafer thin slice for others – you’d get some strange looks wouldn’t you? Well it’s the same with your trades. You need to get the initial risk exposure on each one about the same to keep everything nicely balanced.)
Say you staked £1 per pip on trade A and it’s got a 50-pip stop-loss. That would be an initial exposure of £50. Along comes trade B and that might have a 100-pip stop-loss. If you staked the same £1 per pip on trade B you’d have an initial exposure of £100 – and that’s twice as much as you risked on trade A!
Trade A might give you a 200% profit against your risk (£50 X 2 = £100 profit). And trade B might lose (giving £100 loss). That means you’d be left at break even across the two trades. £100 profit minus £100 loss = £0.
But if you’d standardised the position size – staking £2 per pip on trade A to give both trades an initial exposure of £100 each – you’d have made £100 profit. (£100 x 2 = £200 profit on trade A) minus (£100 loss on trade B) = £100 net profit.
That’s the way to keep the positive probability of trading systems with a profitable edge working for you. If you don’t do this your net returns will be all over the place; there will be no standard ‘unit’ (or equally sized slice) to reward you in an equal manner for each profitable trade that you catch.
So you need to try and get it so each trade’s initial exposure has around the same overall £ value, even though the pip size of the stop-loss will vary on each.
Here’s how you do it…
Let’s say you’re willing to risk 3% of your overall account on each trade. First, work out 3% of your account equity so you know what you can risk on each trade.
If you have a £1000.00 account it might look like this…
- £1,000 ÷ 100 X 3 = £30.00 maximum initial risk available per trade (3%).
Next, work out the number of pips you’ll need to risk on the trade you’re currently working on. Calculate the difference between your entry price and your initial stop-loss price. Here’s the risk on an example Long EURUSD trade:
- Entry (1.10255) minus initial stop loss (1.09775) = 0.00480 (that’s 48 pips).
If you then divide the amount of £ risk available by the number of pips needed by this trade you’ll see how much you can stake per pip: £30 ÷ 48 pips = £0.63 available to stake per pip.
When you come to place the trade you’ll find you’ll be restricted by the fixed increments in which your broker will let you trade: in this example you’d probably have to round it down to 60p per pip, but the key to good position sizing is all about getting the exposure on your trades evenly sized best you can.
Be Prepared: Market Moving Data Coming This Week (London Time)
Wednesday 4th November
09:00 EUR Draghi speaks
09:30 GBP Services PMI
13:15 USD Non-farm employment change
15:00 USD ISM non-manufacturing
Thursday 5th November
11:45 EUR Draghi speaks
12:00 GBP BoE Inflation report
12:00 GBP BoE monetary policy meeting minutes
12:45 GBP Carney speaks
20:15 GBP Carney speaks
Friday 6th November
09:30 GBP Manufacturing production
13:30 USD Employment numbers
Monday 9th November
– no big reports
Tuesday 10th November
- no big reports
IMPORTANT: Keep an eye on the time if you’re trading on Friday: it’s the big report – US job numbers at 13:30!
Trade safely, and until next time, happy trading!
P.S. Don’t forget the Forex Breakthrough Academy is currently open to 50 new students. Don’t miss your place here’s where you can register.