Money Management Basics

What’s the difference between a new trader and a professional trader?

• New traders think about how much they can make
• Professional traders think about how much they can lose.
  • The professional trader knows that one of the keys to winning is knowing how to lose gracefully.
  • 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
    • 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 a trade, we need to be OK with taking on a loss. You don’t have to like it, but it’s best to accept losses as a real component to trading
    • Therefore it’s important to identify and manage your risk effectively
• Be prepared to take on a loss and mange your risk appropriately
• 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
  • Don’t let emotions change your trading approach.
  • Step 1 (before entering a trade): determine where you will get out of the trade
  • If you were to use a wait and see approach to trading, you put yourself in a position to let your emotions take over the decision making process

• Traders who do not identify their risk before entering into a trade can quite often go through the three stages of getting the dreaded margin call

  1. Hope: You hope the market comes back from a losing trade to a winning trade
  2. Wishing: 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.
  3. Desperation: You just watch as the market continues to move against you and eventually the margin watcher feature kicks you out with a big loss.
  • What went wrong?
    • It’s 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.
      
  • Steps to becoming a better trader:
    1. Determine your entry
    2. Identify your risk
    3. Project your potential profit
  • again and again and again
    

• When you toss a coin and choose heads or tails, you have a 50% chance of being correct.

  • What if we win $1 when we’re right and loose $1 when we’re wrong: Break-even Trader
    • To become profitable, one of two things needs to happen:
      1. We need to win a higher percentage of the coin tosses (trades)
      2. We need to profit more when we are right than we lose when we are wrong
    • Most traders prefer to win more when they’re right than lose when they’re wrong
  • What if we win $2 when we’re right and lose $1 when we’re wrong: Profitable Trader
    • Profitable traders know there is no guarantee that nay one trade will be profitable
    • They therefore detach themselves from the outcome of any one trade
    • They know that after a series of trades, chances are good that they will be profitable.
    • Whether it’s a series of ten trades, one month of trades, a quarter or a year of trading
    • They know they’ve been profitable in the past and since they’re using the same approach, the chances are good that they’ll be profitable in the future
    • This is their strength: it’s easy to keep your emotions out of your trading when you treat trading as a business rather than a source of entertainment
  • Be consistent in your approach of how you handle losses, as this is one thing that makes a good trader.

• Goal #1: Think about winning half or our trades.

• Goal #2: Use the classic 1:2 risk/reward ratio.

  • We want to win $2 when we’re right to every $1 that we’re wrong.
  • We risk $1 and look for $2 in profit or more
  • Or, we risk 100 pips when we’re looking for 200 pips or more in profit

• What if the market reverses just before hitting my profit target?

  • There may be nothing more frustrating to see the market move up 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: Move your protective stop to break even once the market moves half way to your target.

• By looking to gain at lest twice as much as you’re willing to risk on your trades and also being able to achieve a winning percentage of about 40% or better, you really set yourself up for a more stress free trading environment.

  • Meeting these two conditions can help you from having to be right all the time

  • You can keep yourself from placing more trades when your strategy isn’t performing as well

    Managing your Account

• How many lots do I open?

  • Consider the following:
  • Account Balance: $5,000
  • Trade Size: 250,000 EUR/USD (25 lots)
  • Pip Costs: $25/pip
  • 100 Pip Dollar Loss: $2,500
  • % of Account Lost on One Trade: 50%

• The problem, of course, is that we could run out of money before winning another trade.

• 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.

• Never risk more than 5% of your account balance at any one time.

  • Example:
    • 5% x $5,000 = $250 Maximum Risk
    • To do this you need to follow two steps:
      1. Determine the stop distance on your trade
      2. Determine the pip cost on your trade
  • This does not mean you can open five trades, each risking five percent; that’s a risk of 25% not 5%.

• There are often many good trading opportunities available at the same time, but depending on the amount of capital 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.

• A mis-trade today will likely bring with it another trading opportunity tomorrow.

Risk Psychology

• Most people are willing to risk more of their account equity at any one time because they hope and expect they will magnify their returns.
• The future is uncertain so we have no way of knowing if market conditions will be favorable to our strategy.
• By limiting our risk, we can maintain more account equity and have more staying power in the market.

Conclusion

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.
   • Risk to reward ratio should be 1:2 or greater
   • Your limit distance should usually be at least twice as much as your stop distance
4. Never risk more than 5% of your account balance at any one time.
5. Obey all rules all the time.