Friday, June 27, 2008

Money Management

Money Management rules tell you exactly how much money to risk on each trade. They also tell you when to add more capital to your trading bank.

In short, these money management rules keep you trading even if your trading rules stop working (or didn't work in the first place).

For example, let's say your trading system used to make a profit 80% of the time. So, because of the great strike-rate, you start using more and more money in each trade. You decide to use a fixed amount of $10K on each trade, even though you only have a $50K trading bank.

Well, 5 losers in a row and you are dead in the water. Even systems with 80% strike-rates can have 5 losers in a row. Very quickly. That's not good money management.

So let's change it and use 20% of your trading bank on each trade. First losing trade you risk and lose 20% of $50K, which is $10K. Now you have $40K.

Second trade you risk and lose 20% of $40K, which is $8K. Now you have $32K.

Third trade you risk and lose 20% of $32K, which $6400. Now you have $25,600.

Fourth trade you risk and lose 20% of $25,600, which is $5120. Now you have $20,480.

Fifth trade you risk and lose 20% of $20,480, which is $4096. Now you have $16,384.

So, you can see that using a fixed amount of money lost us everything in 5 trades. Using a percentage of your trading bank adjusts itself each time, so that 5 losses in a row still leaves us with money.

And there aren't too many people that suggest you risk 20%. Most people seem to say between 1% and 3% of your trading bank is all you should have at risk on any one trade. Even if you had a string of losers, risking just 3% of your trading bank is going to keep you trading for a long, long time.

The downside, of course, is that by risking so little, your profits aren't going to be so big. Frustrating if you're just starting out. But let's not forget the oft-quoted 80% (or 90%, or 95%, whatever) of traders who quit or lose their money. Perhaps, expecting only to profit, they risked too much of their bank.

So that's Money Management. Do you use a fixed amount of money on each trade? Do you use a percentage? Easy.

There's some other stuff about when to add money to your trading capital. I remember "pyramids" and other things in a book I read by Daryl Guppy (his books started me off on the technical analysis journey). For me, I just use 2% of my trading bank, and the trading bank fluctuates as I make and lose money. Essentially it means I add the money to the bank straight away.

For currency trades, the calculation is:
A. Get total trading bank.
B. Get 2% of A. This is how much money we want to risk.
C. Get pips at risk in the trade to be opened.
D. Get $ per pip of the currency of the trade ($10/pip for currencies ending in "USD", variable for others).
E. Multiply C with D. This gives us how many dollars would be at risk if we traded 1 contract (1 contract = 100,000 units).
F. Divide B by E. By dividing the amount of money we have to risk, by the amount of money risked if we traded 1 contract, we can get the number of contracts that we are able to trade.

We now have a figure like 0.869 or 1.342. It's up to you and your broker what you do now. You should always round down so that you are actually risking less than the maximum amount you said you wanted to risk.

If you use Oanda, then you can actually trade 0.869 or 1.342 contracts, which equate to 86,900 and 134,200 units respectively.

If you use FXCM's mini account, you need to round it to the nearest lot of 10,000 - 80,000 and 130,000 units.

If you use a broker that allows only whole-numbers of contracts, then 0.869 means you can't trade until you get more money from somewhere, or you find a trade risking less pips. 1.342 means you can trade with 1 contract.


Joko Nurjadi said...

agree, money management is very important, that's why i think MM is a requirement for trading/investing, but MM is not a secret.

This means every investors should use MM, but winning investors shouldn't use MM only. I told this because i heard many people said MM is the secret to survive in market, I don't think so.

For example, 5 losses in a row like described above is very possible, so $40K down to $16K is very possible also, and this is not a "survive".