“A good trader with bad money management will blow up one day”
Few Things About Smart Risk Management Every Forex Trader Should Know
This is a quick introduction to risk and money management for forex traders.
The point to drive home from this lesson is:
You need to pat pay a lot of attention to your money and the way you treat it when trading.
Learn about odds, expectancy and other important statistics.
It does matter
When people first come to trading and in particular Forex the first thing they do is to find the fanciest trading system they can.
The thinking goes if they can just find the latest and greatest system – all their dreams will come true and the millions will come rolling in.
Whilst a solid and profitable trading method is needed to make money trading,
if the trader does not use a proper money management to fit that system or method
then the best trading system in the world is not going to help them.
The most profitable trader in the world could personally tutor a trader and give them all their tricks and tips, but if that trader fails to use solid money management, they are still doomed to fail!
This is how important money management is.
Unfortunately, it is something that is constantly overlooked.
Traders often spend months or even years testing system after system but never finding the one that is profitable for them.
Maybe it’s not the systems that are failing, but perhaps there is something else the trader is doing which is causing them to consistently fail?
so the purpose of this article is to teach you how to treat your money while trading.
“The creation of speculator’s wealth comes from how they manage money, not some magical mysterious system or alchemist’s secrets. Successful trading makes money and successful trading with proper money management can create immense wealth!”
“I’m always thinking about losing money as opposed to making money.
Don’t focus on making money, focus on protecting what you have”
Paul Todor Jones II
We take risks every time we step outside our door in the morning.
Just the act of getting in the car in the morning and taking the highway to work is a risk involving the potential for flat tires, a car accident, heart failure or more.
We live in an uncertain world. Risk is in our lives at all times no matter what we do, and it cannot be eliminated.
The best we can do is to limit it as much as possible.
Risk is a threatening word associated with negative outcomes.
Risk has the potential to result in calamity or destruction.
We all know what happened to
Barings Bank PLC
Long Term Capital Management
Individuals and companies make choices every day – which risks and how much risk they are willing to assume at any point in time.
For example, most individuals buy car insurance with a deductible limit for the various coverage elements, such as collision insurance.
Some may have a $500 deductible policy, while others are comfortable with$2,500. But the vast majority of us chose to limit this risk as much as possible.
Businesses and firms who sell products abroad or import significant amounts of raw materials are exposed to foreign exchange risks and chose to limit their exposure via numerous tools like futures markets or hedging.
No matter what methods they use, they are aware of the risks, they measure their risk and control it.
Risk is quantified and managed in the Army, in mining, environmental industries, gambling, in the finance industry…Everywhere…
For the purpose of this course we will concentrate on risk and its management in relation to Forex Trading.
DEFINITION OF RISK IS:
There are many definitions or “risk” but my favourite is the one from a famous trader Ed Saykota.
“RISK is the possibility of loss. That is, if we own some stock, and there is a possibility of a price decline, we are at risk. The stock is not the risk, nor is the loss the risk.
The possibility of loss is the risk. As long as we own the stock, we are at risk.
The only way to control the risk is to buy or sell stock.
In the matter of owning stocks, and aiming for profit, risk is fundamentally unavoidable and the best we can do is to manage the risk.”
Ed clearly nailed it saying that the risk isn’t the loss itself or the asset we buy or sell, the risk is the POSSIBILITY of a loss, which cannot be avoided.
It can only be properly managed.
Every time we take a position in the market we run into the possibility for a loss of our position and the money behind it.
It cannot be avoided.
Speculative trading is a highly risky ACTIVITY and losses are part of the game.
The trader’s job is to quantify and control the possibility of losses., Furthermore if risk is unavoidable we must accept it and reduce it as much as possible.
- We will always incur losses when trading
- We will not be able to eliminate them fully
Every time we press the “NEW ORDER” button we speculate if the currency goes up or down putting our money on the line.
Furthermore, statistics say:
- We cannot know the outcome of a trade
- We cannot know how far the price will move
- We will be wrong at least 50% of the times
We trade in a highly volatile and unpredictable environment where only a few made consistent profits in the long run.
The odds are bad and we could lose a lot of money quickly
This is why a proper Money management is a crucial component of the trading process.
Nevertheless, many traders either ignore or simply refuse to understand how important it is.
They focus on other aspects like entry strategies instead.
“An accurate trading strategy is simply not enough to generate income … and
a bad money management destroys many accurate trading strategies”
My advice is:
Stop focusing so much on where you enter the market, it doesn’t matter a huge amount in the long run. instead
Start focusing on what happens AFTER you enter the market
This is where you are going to make real cash OR fail
Accuracy often has little to do with profits
A system could be 90% accurate and lose a lot of money or be
30% accurate and make a lot of money
Systems with 90% accuracy are statistically dangerous and will eventually blow up.
It’s simply impossible to be 90% right on the markets in the long run. If the system shows to be 90% accurate in the short term, it will eventually revert to the mean.
Nevertheless, many traders are attracted to these systems. And this is because humans are risk averse.
We don’t know how to deal with losses and we don’t want to experience them. It hurts; hence we are attracted to systems that have no losses.
Unfortunately, trading is a game that requires us to often act against our human instincts
Trading requires a great deal of discipline and patience – these are rare qualities in humans.
Trading is a game of probabilities and money management.
An Entry strategy only defines where you enter the market.
Risk management defines how much you enter and how much you exit
If this was a war
Your strategy is your tank.
Risk management is the battle plan
Which one do you think is more important? The tank or the battle plan?
Trading too much and betting too much will cost you far more than bad market calls
Everyone knows that money management is a crucial aspect of trading. Yet most people don’t spend enough time developing a suitable plan.
Many traders I talk to are unaware of the basic concepts of effective money management and this is why so many of them fail to produce profits in the long term.
We have all heard the statistic that something like 90% of traders fail to make money in the long-run trading forex
Do you think so many fail because they trade bad entry strategies?
Or perhaps they fail because they:
- Risk too much
- Cut their winners short
- Hold on to losses etc
How does proper money management allow you to maximise profits and save you from destruction?
Prices reflect human nature therefore prices trend.
Humans tend to move from fear to greed – creating :
- booms and busts
- bubbles and collapses
- bull markets and bear markets
They happen on a regular basis. This behaviour creates trends.
Depending on the market and the definition of a trend, prices tend to trend 60% of the time.
Meaning when a certain level is broken through, the price is likely to move in that direction for a while.
Trends create opportunities to profit for those who are patient and have the capital to trade.
For the remaining 40% of the time, prices will move sideways or will consolidate.
These periods often create drawdowns and shake off weak players with no plan.
This is how money is made in trading:
“Trading is about making a lot of mistakes to finally score the home run.”
Great traders make many small losses trying to catch the next big move which will cover all incurred losses and will double your account, hence the saying
“cut your losses short and extend your winners”
It’s that simple. But
It comes down to a proper money management system that is designed to catch and ride big moves and absorb small losses. The bottom line is:
We don’t know when the next big trend will start.
We don’t know how far it will go
We can only try to catch the next big trend
We can do it by taking positions in the market
A Trader needs to have a clever money management plan that
- is set to catch the long-term trend
- is set to ride the long-term trend
- is set to limit loses in consolidation when it happens
- is set to preserve and maximise the trading capital always
because what normally happens is:
- Traders hold on to losses in the consolidation period, draining their capital
- Traders are unable to recognise trends when they start to unfold
- Traders take on too much risk and have no capital left when trends finally unfold
- Traders cut their winners short and catch only a fraction of the trend
- Traders, by setting take profit levels and trading single positions often deprive themselves of profits and expose themselves to more risk.
- Traders often try to re-enter trends and incur more losses during short term corrections
Here are some other reasons to think about.
solid money management does few jobs for us
1) It looks after your downside and allows your upside to take care of itself
This is exactly what Paul Jones meant. Proper risk management takes care of your losses, while ensuring that the upside takes care of itself.
You just need to have the patience and discipline to sit through it.
2) It will ensure a trader’s mistakes are corrected, and losses are compensated
Your losses mean, you were wrong with your analysis and the price went against you. It’s normal to be wrong. In fact, statistics expect you to be wrong more than 50% of the time.
Proper risk management ensures you will get back what you lost and come back with profits on the top.
You should always have sufficient reserve capital in case you incur many consecutive losses to stand up and fight another battle.
This will happen.
You need to be ready
3) It is protection from losses but also a tool to recover from draw-downs
Proper risk management not only protects your capital from destruction but also ensures swift recovery from the drawdown periods.
You need a tool to provide you with confidence when you run into periods of losing trades. More about this in later lessons
4) It helps you to make sound decisions in an unpredictable environment
When you clearly define your risk and control measures, you will have a clear expectation of future outcomes.
Your mind should not be clouded and your decisions should be made based on statistics.
Your heart will not beat faster with another loss. You will be indifferent to losses.
5) Are you picking up dollars or creating wealth?
You need to devise your money management system to be able to maximise profit opportunities that the market gives you.
If you go in and out catching a few pips here and there, it’s unlikely you will survive in the long run.
Big money is made on daily and weekly charts so ZOOM OUT!
6) You can’t improve if you can’t measure
If you cannot measure something, you cannot improve it. You should know all statistics of your system before you trade it.
The most important stats should include: risk and reward ratio, expectancy, average loser, average winner.
Like any other business, your system needs KPIs in order to constantly improve it.
“Money management strategy is a statistical tool that helps control the risk exposure
and profit potential of every trade activated.”
Many traders get caught up in fads and do not pay attention to proper money management. As a result, the lose money that never had to be lost.
The two biggest reasons why people lose money are improperly used stop-losses and trading positions that are too large.
The problem of losses is especially big among novice traders who lack the ability to properly plan a long-term strategy. Do you want to become a better trader?
Learn about the five key elements of risk management forex traders must know to become successful in the long run.
Stop loss determines the acceptable loss a trader is prepared to take.
Entering trades with just calculated profit targets can be disastrous if you have not clearly calculated a protective stop loss.
Money management will advise in determining a realistic risk:reward ratio that will limit the effects of draw-downs and they will help you in selecting essential accurate stop loss and target limits for each trade entered.
New trading systems should be back tested using historical data with the objective of producing positive win:loss ratios and expectancy values.
The above mentioned analysis will help you in estimating a realistic and measured performance of the capabilities and limitations of the trading system.
In particular, you will know how many losing trades might be encountered during an overall profitable period of time.
This knowledge will help you during periods of adversity so you can still persevere with your system by trading in a consistent manner.
All types of trading are unpredictable and even sure-fire deals can turn surprisingly bad in a matter of moments.
One thing you have to keep in mind is that losses will occur no matter what. They are cost to this business.
While you can’t stop them from happening, you can limit the amount you’ll lose.
You can use a stop-loss to curb your losses by setting the order for amount of pips away from your entry point or a certain percent below the price you purchased the stock for.
Taking this action will limit your total loss to just the amount you set it to.
While it can be hard to take a hit, it is far less painful than experiencing a deeper dip.As prices trend, setting stop loss will limit amount of losses you have.
If you are being stopped out, the price had reversed and it is likely building a new trend in the opposite direction. You need to get out!
The biggest rule to follow when pursuing profits is to leave your emotions behind.
It is important to have a predetermined exit strategy in place so emotions don’t cloud your judgment and cause you to react impulsively.
Traders who act on emotion can expect to walk away with lower profits than those who trade based on logic and discipline.
The trick is to let winners run and make you some money. While it may be tempting to walk away from the table once you’ve made a small profit, it is important to resist the urge to be content with small gains.
Train yourself to avoid manually exiting a trade whenever you see things move against you. The zigzag motion of the market means it’s probably only a matter of time before things swing back in your favor.
A better strategy is to wait for the market to take you out.
Make a plan to set your trades and stay committed to letting the ebb and flow of the market determine whether you make a tidy profit or a small loss.
Move your stop losses closer to new lows/highs printed by the price. This way you lock in more profits and ride the trend.
In the chart below, trader moved take profit levels after the price action produced lower high within the uptrend. He was able to ride most of it with small risk while collecting interest.
Or a simple manual plan would be to trade in batches of three. Then you need to pick 2 target areas to lock in profits.
Let lot 1 run to target area 1 and take profit; let lot 2 run to target area 2 and take profit.
Finally place lot 3’s stop to breakeven and let it run until your strategy’s exit condition is met.
If the events occur as planned, the worst thing that can happen to you is that you have 2 profitable targets and a third that could be stopped out at breakeven.
This sounds easy but it is not.
Why is it so hard to hold on to winning trades?
The emotion of fear comes into play because the sight of large profits entices a trader to take profit early before a possible rebound occurs producing a resultant loss.
Also, watching a profitable trade reverse, invokes many mind-numbing emotions that cripple the consistency of trading decisions.
After consequent losses, traders suffer confidence drops that again produce a tendency to make them snatch early smaller profits before the real earning potential arises.
Sadly, many forex traders enter good opportunities but either takes premature profits or is stopped out.
They then watch in frustration as the trade proceeds in their chosen direction amassing sizeable profits without them participating; an aspect which can easily result in overtrading.
If you are a trend follower and are taking breakouts in many different markets hoping to catch a large move, it is crucial that you let your profits run.
Trying to design a trading system capable of capturing large trends generates many human emotions such as regret, revenge, and greed that have devastating effects on the standard of trading decisions.
A loss always requires a bigger win to recover.
This is one important rule that you need to understand in order to become a successful trader.
Size is a big factor when it comes to making a profit in forex trading. It is important to avoid risking more than 1 percent to 2 percent of a trading account at one time.
It is important to always remember that increasing lot sizes directly increases the amount of risk you’re exposing yourself to.
In fact, increasing risk too greatly and too soon is that primary reason why accounts blow out.
Establishing your position size should be done with much thought and preparation.
Take time to do some calculations that will help you determine how long it will take you to recover your equity if you risk 5 percent or 10 percent at a time.
A Simple graph below will show you the recovery process after risking certain amount
Be Ready for a Losing Streak
It’s important to think of investing as a race rather than a sprint. It is important to prepare yourself mentally and financially for losing streaks.
In fact, you can expect to experience 10 losing trades in a row at any given time if you will be placing thousands of trades over the course of a few years.
It is important not to let discouragement and unrealistic expectations leave you vulnerable to impulsive trading techniques.
If you want to trade for the next 10 years, how many traders do you think you are going to place? It will be 1000s!
Prepare to get 10 losses in a row. It will happen!
Stay Alert and Avoid Mistakes
Being an investor is like signing up to be a lifelong student of the financial world.
You have to continuously seek out market knowledge and stay educated on the factors that affect what’s happening to your money.
The most valuable lesson of all to take away in order to be a successful long-term forex trader is that the biggest hurdles to overcome in the financial world are often the emotional ones.
Arming yourself with a logical, systematic plan is the best way to make sure you don’t make a foolish decision in the heat of the moment.
You must appreciate quickly that the most successful forex traders are first skillful survivors and secondly big earners.
Even a trading system mediocre but positive expectancy can be turned into a money machine with the right money management techniques.
Money management is a study that mainly determines how much can be spent on each trade with minimum risk.
For instance, if too much money is risked on a single trade then the size of a potential loss could be so great as to prevent users realizing the full benefit of their system’s positive expectancy over the long haul.
The important concept is “do not risk too much of your balance at any one trade”.
If you strive to integrate these ideas into your trading strategy backed by the concepts of the risk:reward ratio and winning percentage, then you will greatly increase your chances of successful forex trading