One of the most important aspects of trading is money management. An individual trading with proper money management will do better trading a mediocre trading system than a person trading an excellent trading system who lacks money management skills.
Every good trader has a strict set of money management guidelines that he uses. A trader can’t expect to eliminate risk. However, he can take measures to effectively manage it. In order to properly manage risk, he must first identify what risks are involved and apply the appropriate risk management technique.
“RULES THAT YOU WON’T
FOLLOW DON’T MATTER”
No matter how good a risk management system is it won’t have any impact on your trading if you don’t apply it.
There are 5 basic components to any money management program.
- Currency Selection (Volatility)
- Lot size (How much margin will we use)
- Stop Placement (How much margin to risk)
- Entry Level (When no to trade)
- Limit (How much money will we make)
Currency Selection
We must first decide what currencies we will trade. Why is this important? For example, the EUR/GBP moves very slowly. If we enter a trade on this currency, we must be aware of the possibility of having our margin tied up for a long period of time. The longer we are in a trade, the more risk we take on due to the possibility of political upset, fundamental announcements, etc. This also affects our ability to enter additional trades because it ties up our margin.
Trade Size
The decision regarding how much to buy or sell is absolutely fundamental yet is often overlooked or improperly handled by most traders. The amount which a trader buys or sells affects both diversification and money management. By diversifying, we spread the risk over multiple currencies which increases the probability for profit by increasing the opportunity for catching successful trades. In order to diversify properly, we must make similar, if not identical, trades on many different currencies.
THE PURPOSE OF MONEY MANAGEMENT
IS TO CONTROL THE RISK . . .
. . . by not overextending your margin and putting yourself in a position to have a margin call. This concept is the single most important aspect of trading in regard to rules. The majority of beginner traders and many seasoned traders greatly increase their chances of failure by overextending themselves and using poor money management before they are able to swing the odds in their favor. With that said, let’s break down the process of choosing the proper lot size. In order to correctly calculate lot size we must first decide on a few rules. The rules are as follows:
- Maximum allowable risk overall
- Maximum allowable risk per trade
- Desired Stop Placement
Maximum Allowable Risk
This defines the amount of money you are willing to risk in total between all the open positions. For example let’s say you are using 3% as your maximum allowable risk and you have $100,000 of available margin. This means that you can never have more than $3000 exposed at any one time. How do we calculate our exposure? This is calculated by taking the traded currencies pip value and dividing it by $3000. Currently, the EUR/USD is worth $10 per pip per lot. Therefore 3000/10 = 300 pips. If 300 pips is our maximum exposure, then the combined pip count of all our stops can’t equal more than 300.
Maximum Risk per Trade
This defines the amount of money you are willing to risk on a single entry. I suggest no more that 1.5% to 2% on any one trade. This will allow for additional positions to be added and doesn’t use your entire available margin. This is calculated the same as Maximum allowable risk only using the 1.5% figure instead.
Desired Stop Placement
In order to decide Lot size, you must first decide where the optimum place to put your stop is. Let’s assume that you are using a support that is located 30 pips below our entry and you plan on setting your stop 5 pips below that. You have the same margin in the example above and are only going to risk 1.5% on a single trade. 1.5% of 100k is $1500.00. Therefore, you can risk a maximum of 4 lots, assuming you get stopped out at 35 pips. This would equal $1400.00, so the trade size would be 4 lots at the most.
Stop Placement
As a trader you must learn to embrace your losses as they will save you tons. This may sound quite hypocritical. However, it is something you must learn to accept. Traders who do not cut their losses will not be successful in the long term. The most important part of this concept is to predefine this level before entering the trade. Using the information above in regard to calculating acceptable losses along with support and resistance levels will give you a good idea of where to place your stops.
Entry Level
When considering an entry, you must understand the process of calculating the maximum allowable risk per trade. Let’s assume that you have multiple trades open and you receive a sell signal on the EUR/USD. You have $20,000 in available margin after allowing for the stops that are in place on the existing trades. Assuming a 1.5% risk allowance, that would allow you $300 to play with.
If the nearest resistance was more than 30 pips away to properly trade, your stop would need to be above that level. With each pip worth $10 dollars, that stop would cost more than $300. Therefore, this trade should be passed on. You should have your trade planned before entering. You should know stops levels, expected profit targets, risk reward ratio, and your available margin, etc. Bottom line, your entry should be close to a support or resistance.
Limit Level
It is important to have a target in mind when entering a trade, otherwise there is no way to compare the risk to reward. If you have a target and it is only 18 pips away, it would not be wise to risk 30 or 40 pips to capture that move. When taking a position in the Forex, or any other market, be sure that the possible profit is at least equal to the accepted risk. When trading a system that has proven to be profitable, proper money management will ensure that you are able to weather the losses in order to be around when the trade goes your way. After all, if you have a system that is 70% accurate and you lose the first 30 trades out of 100, you better have enough margin left to trade for the next 70.
Hedging
There are many misconceptions as to why a trader would hedge a trade. I would like to clarify that hedging serves one purpose and one purpose only . . . limiting risk. The fear of being stopped out can be eliminated by using proper hedging techniques. If a hedge entry is properly managed, the worst possible turn out is a minor loss. However, there is a downside. Resolving an active hedge order may require some patience due to the nature of the trade.
When hedging, there are two approaches: wide and narrow. Both methods have advantages and disadvantages depending on the objective of the trader. A hedge order is a trade place in opposition of an existing trade of the same currency pair. The majority of the brokers do not allow this. Therefore, you must first verify with your broker that they do allow hedging, otherwise an attempt at a hedge order will result in canceling both trades.
A hedge order is a great alternative to a stop and should be used for the same purpose: limiting risk, and not necessarily making profit.
“LOSSES ARE INEVITABLE AND TRADERS
MUST MANAGE THESE LOSSES”
When our stop is hit, we are done, and there are no second chances. However a hedge position allows for some flexibility and maybe even some profit. The initial order is our primary focus for profit. The hedge order merely allows for less of a blow to our margin when the market does something unexpected. Another advantage of hedging is the ability to increase or decrease position sizing on the hedged position. For example, if our first entry is long on the EUR with 2 lots, our second position is entered short with 1 lot or even 4 lots. I would only suggest entering with more lots if you have strong indicators telling you that the market is going to continue against your first entry.
When managing a hedge you must realize that it is to be treated as a standalone trade. Caution must be taken when closing a hedge trade when the primary entry is in the negative. You should immediately place a second hedge order at your regular stop distance in order to protect the primary trade.
Many people have a problem grasping the concept of hedging, but be assured that this is not a complicated method. Simply manage it as if it was a standalone trade, and this will simplify things significantly. If you are trading on a platform that doesn’t allow hedging, you may still use this strategy. However, it requires 2 separate accounts. All hedge orders will incur the standard broker fees and margin requirements in place.
The first thing to do before hedging is to open a demo account and practice, practice, practice. As with any new concept in trading, you must experiment with it until you are confident in your ability to manage a trade that has been hedged. Secondly, always place your hedge order at the place you would regularly place your stop. The objective is not to have your hedge order triggered only to protect your primary entry.
The worst case scenario is the hedge position is brought in and the currency reverses again. At this point you have two options. The first of which is to ignore the pair completely (both the initial order and the hedge) and compensate the negative with a later trade. The second option is to place an additional trade in line with the primary entry with multiple lots. This should only be done if you are trading with the overall trend and you have a valid reason to enter the trade. This trade must be hedged as well. You would place the hedge order at the proper stop level just as if this were a new trade.
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