Money Management

Money Management Lesson 1
What is the difference between a new trader and a professional trader? This is a question
we get asked quite frequently. Of course there are many differences, but the main
difference is this:
New traders think about how much many they can make while professional traders think
about how much money they can lose.
Think about that for a moment. These are two opposite attitudes. At first you may wonder
how a trader can make any money when they are focusing on a potential loss. But the
professional trader knows that one of the keys to winning is learning how to lose
gracefully. Why?
One of the most consistent realities in trading is that if you trade long enough, at some
point in time you will likely have losing trades. But how you manage those losses has as
much to do with your long-term success or failure as just about any other factor in trading.
When we enter into a trade we need to be okay with taking on a loss. We don't have to like
it, but its best to accept losses as a real component to trading. Therefore, its important to
identify and manage your risk effectively. We argue that the potential to be consistently
profitable increases with the use of protective stops, which help get you out of a trade when
the market moves against you.
Emotions can run very strong when your trades turn into losers. Thats why we feel the first
step before entering into a trade is to determine when you are going to get out of the
market. If you use a wait and see approach to trading, you put yourself in a position to let
your emotions take over your decision making process. Traders who do not identify their
risk before entering into the trade can quite often go through the three stages of getting the
dreaded margin call. First comes hope....you hope the market comes back from a losing
trading to a winning trade.
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When hope doesn't work, you try wishing. You wish the market will come back enough to
get out at the price where you got in so you don't have to take a loss. Then comes
desperation, where you just watch as the market continues to move against you and
eventually the margin watcher feature gets you out with a big loss.
What went wrong?
It is hard to make good decisions "in the heat of the battle". If you have real money on the
line, you tend to make decisions based on fear or greed. We need to make decisions based
on sound analysis rather than the need to just get out of a trade.
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How many times have you finally gotten out of a bad trade and then see the market reverse
and move back in the direction you wanted? It has happened to all of us. But those who
decide not to let this happen to them anymore take a big step to becoming a better trader.
So, determine your entry, identify your risk, and project your potential profit again and
again and again.
Think about tossing a coin for a moment.
When we toss a coin and choose heads or tails, we have a 50% chance of being correct. But
what if we win $1 when we are right and lose $1 when we are wrong? Basically, we put our
self in a position to be a breakeven trader. So, to become profitable, one of two things
needs to happen.
1. We need to win a higher percentage of the coin tosses...or....
2. We need to win more when we are right than we lose when we are wrong.
Most traders prefer to try to win more when they are right than they lose when they are
wrong. Now what if we win $2 on that coin toss when we are right and lose just $1 when we
are wrong? The answer is of course that we would more likely be consistently profitable. I
would want to toss that coin 24 hours a day, seven days a week since I have the numbers
on my side. Remember again, it is a 50/50 coin toss.
Even if I lost five coin tosses in a row, I would take that sixth toss as a trading opportunity.
Why not? There is nothing wrong with the coin or what I was doing, so I would remain
consistent in my approach. Profitable traders take a similar position, knowing that there is
no guarantee that any one trade will be profitable. They therefore detach themselves from
the outcome of any one trade. But they know that after a series of trades, chances are good
that they will be profitable.
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Whether it is a series of 10 trades, one month of trades, or a quarter of a year of trading,
they know they have been profitable in the past and since they are using the same
approach, the chances are good that they will be profitable in the future. This is their
strength. It is easy to keep your emotions out of your trading when you treat trading as a
business rather than as a source of entertainment. Be consistent is your approach and how
you handle losses as this is one thing that makes a good trader.
Let's continue with the coin toss analogy. We should think about winning half of our trades.
Its true, some new traders find a way to win 75% of their trades. The problem is that they
win a little while risking a lot. We have seen new traders win 10 pips on a trade. Then win
another trade with a 10 pip profit. Then perhaps even one more. But when they try to win
10 pips on the fourth trade, the market does not behave and they may end up losing 50
pips on the trade in an effort to win 10 pips.
This happens way too often as the trader wins three out of four trades or something along
those lines, but still manages to lose 20 pips on the series of trades. This obviously will not
work.
What does work?
I hope you already have the answer. The answer is to win $2 when we are right for every
$1 that were wrong. This is simply the classic 1:2 risk:reward ratio. We risk $1 and look for
$2 in profit or more or if we risk 100 pips, we look for 200 pips in profit. We want to try to
win 50% of our trades and make more when we are right than we lose when we are wrong.
This is achievable, even for new traders. But you have to accept it and use it in your
approach to trading for it to work for you.
Another good question to ask is what if the market reverses just before hitting my profit
target?
There may be nothing more frustrating than seeing the market move up to within a few pips
of our target only to see it reverse and move back to stop you out with a loss. So let's not
let that happen. We recommend moving your protective stop to the breakeven level once
the market moves halfway to your target. Here is an example:
1. Lets say you buy the EUR/USD at 1.4500.
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2. You place your protective sell stop at 1.4400 for a risk of 100 pips.
3. You place your limit order to take profits at 1.4700 for a potential gain of 200 pips so we
have a 1:2 risk: reward ratio.
4. When/if the market moves halfway to our target which would be the 1.4600 level, we
move our stop from 1.4400 up to our entry of 1.4500. This means that at this point we can
break even or profit 200 pips on the trade. Which is a nice position to be in.
The other main point of money management is how you manage your account. So a good
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question to ask yourself before entering into a trade is, how many lots should I open. To get
a better understanding of how to determine this, consider the following. Lets assume you
have a $5,000 account balance and you place a 25 lot trade on the EUR/USD. Thats
250,000 units, which means your cost per pip is $25. Lets assume youve prepared for a
100 pip loss on this trade. A 100 pip loss at $25 per pip comes out to be $2,500. With a
$5000 account balance, it doesn't make much sense to open 25 lots and risk half of your
account balance on a single trade, does it? Remember the coin toss? What if we were to
lose five trades in a row in spite of a long-term 50% win ratio on our trades? The problem of
course is that we could run out of money before winning another trade. So we want to risk a
limited number of pips and a limited amount of our account balance so we can continue
trading, even after a few losses. We recommend not risking any more than 5% of your
account balance at any one time. To get a better feel for calculating your trade sizes so that
you can achieve this goal, lets go through some calculations together.
First, 5% of $5,000 is $250. To make sure that you dont risk more than 5% of your
account youll want to risk no more than $250 at any one time. To do this, youll need to
follow two steps. The first step is to determine your stop on the trade. Lets again assume
youre willing to risk 100 pips on a particular trade. Next, youll need to find out the
pip/cost, per 10K lot for the pair youre trading. You can view the per lot pip cost from the
Pip Cost column within the Simple Dealing Rates window of the platform. For this example
lets assume were trading the USD/JPY, which has a per lot pip cost of about 1.10. If we
multiply that by the 100 pip stop loss we get a dollar loss of $110. So far so good. What if
we double our trade size from 1 lot to 2 lots? That would mean our pip cost doubles and
goes from $1.10 per pip to $2.20 per pip. So a 100 pip loss trading 2 lots would be $220
still under $250 maximum that we had. But what about 3 lots? With 3 lots our pip cost goes
up to $3.30 multiplied by a 100 pip loss and we get $330, which is more than $250 or 5%
of our account. So at a maximum well want to trade 2 lots on this particular trade to stay
within these parameters.
I have to take a moment to strongly emphasis something. Notice that our recommendation
was to not risk more than 5% of your account balance, at any one time. This does not mean
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that you can open five trades each risking 5%. That is a risk of 25%, not 5%. Youll often
find that there are many good trading opportunities available at the same time. But
depending on the amount of capital you have available to you and the risk that each trade
has associated with it, you might not be able to act on all of them. Patience and
consistency are key. And remember, a missed trade today will likely bring with it another
trading opportunity tomorrow.
To conclude this video, lets sum up what weve covered:
1. Identify where you are going to get out before you get into a trade.
2. Use a protective stop and have it in the market whenever you are in a trade.
3. Use a 1:2 risk: reward ratio so you can be profitable if you win half of your trades.
4. Never risk more than 5% of your account balance at any one time.
5. What else? Obey all rules all of the time!
This concludes our introductory video on money management.
Thanks for watching this video and good luck with your trading.
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Money Management Lesson 1