Money Management, A Critical Part Of Trading
Money management is a critical point that shows difference between winners and losers. I can explain how critical it is by using an example of, 100 traders using a system with 60% winning odds, with only a handful of traders being profitable at the end of the year. In spite of the 60% winning odds, the majority of traders will lose because of their poor money management. In the industry it is said that only 5% of traders are profitable. That leaves a staggering 95% of market participants as losers. Money management is a very significant part of any trading system with most traders not understanding how important it is.
As a trader it is very important to understand the concept of money management and understand the difference between it and trading decisions. Money management represents the amount of money your are going to put on one trade and the risk your are going to accept for this trade.
There are different money management strategies but they all aim at preserving your balance from high risk exposure.
Core Equity of your Account…
First of all, as a trader your must understand the following terms of Core Equity of your Account.
Core Equity = Starting Balance – Amount in Open Positions.
As an example, if your have an Account Balance of $10,000 in your account and you enter a trade with a risk of $1,000 then your core equity is $9,000 that is remaining in your are account. If you then enter another $1,000 trade, your core equity will be $8,000 remaining in your are account.
It is important to understand what Core Equity is and means since your money management will depend on this equity.
Reward to Risk is simply R:R…
As traders, our aim is to control our risk by having a predetermined risk dollar amount on each and every trade with an aim to achieve and return a high reward. Once you get trading you will hear other traders mention R:R per trade. It simply means your Reward to Risk.
Some use the terms in the opposite direction but it really doesn’t matter which way, as it still describes the same meaning. I was taught that reward is the front number and when describing a 2:1 R:R it means that we aim for 2 times our 1 risk. So, we aim for a $200 Reward for a $100 Risk as an example. If your hear others mention the opposite it is always best to ask for clarification on their interpretation of R:R so your can follow along with them.
No way is incorrect, it is just a preference thing. Just make sure who ever you talk with about R:R that you understand their meaning. Be very clear and take note that trading with a smaller reward to risk is not an optimum trading strategy or plan, and these are traders that risk being part of the 95% group of traders if they don’t know or understand what R:R is all about. It doesn’t necessarily mean that they won’t be profitable, but they will need to keep their win rate high to be successful at trading.
Trade Win Rate…
Having a high win rate doesn’t mean you can be a successful trader. It doesn’t mean that you can’t be a successful trader either but it is a safer option to try to find a strategy that the rewards are higher than what the risk is.
As a high win rate trader with a small R:R, it means that you can have many small winning trades and then just a few losing trades that can wipe out all of the gains from the small wins. As a trader with a high R:R, it means that you can get many trades wrong, but because the dollar amounts are bigger from the winning trades than the losing trades you will still make money.
Win Rate to R:R Ratio:
- 1:1 R:R means you need to have a 50% Win Rate to Break Even (BE)… 5 win trades and 5 loss trades
- 1.5:1 R:R you need a 40% Win Rate to BE… 4 win trades and 6 loss trades
- 2:1 R:R you need a 33% Win Rate to BE… 3.3 win trades and 6.7 loss trades
- 3:1 R:R you need a 25% Win Rate to BE… 2.5 win trades and 7.5 loss trades
- 4:1 R:R you only need 1 win trade against 4 loss trades to be at BE
I think you get the point here. The higher the R:R, the less trades you need to win to have a higher chance of staying profitable. Although, it is easier said than done.
Smaller Win Rate to R:R Ratio:
- 0.7:1 R:R your need a 60% Win Rate to BE… 6 win trades and 4 loss trades
- 0.3:1 R:R your need a 75% Win Rate to BE… 7.5 win trades and 2.5 loss trades
Which do your think is better? Well, in forex trading it is not uncommon to have a losing streak of 6 trades in a row or even more and even the pros have been down this path. But with a high R:R they survive to trade another day. It’s all about the long game and staying in the industry for the long term.
Some of the best traders have a low win rate but high R:R, and these are people that have been in the industry for a very long time. It’s OK to lose, but lose small and win big. Wait for the best probability setups and take them. Trade less and win more.
Pips Verses Percentage…
When you first start trading you will hear people talk about how many pips they made on a certain trade or how many pips their stop loss is. I was taught very early in my trading career not to count your trading success in the number of Pips you make, but how much Percentage have you made from your trading. In fact, counting pips is almost irrelevant.
Instead, when you are trade you should always trade with percentages. Trading by way of percentage is how the pros do it and let’s face it, what do your hear on the financial news? You don’t only hear how many dollars an instrument has moved, gained or lost. You hear how much percentage it has moved. When you deposit money in the bank you earn interest measured by percentage. When you receive your financial investment report you check how much percentage gain or loss it has made for the year or term.
So we do the same with our trading. We measure by percentage. We measure the percentage risk and the percentage gain on every trade we make. We also measure by percentage on how much of a gain/loss we make each month, quarter and years end.
Ulitmately, we count the dollars as well but what we want to learn is how to make a consistent percentage return over a period. If you can earn a stable percentage then the dollar account size will follow eventually.
The strategies that I use, I always measure in this manner and I normally risk an amount of 0.25 – 0.50% risk per trade of my account core equity size. This does not matter what the currency pair is, nor does it matter what the time frame chart is that I trade.
By using percentage it doesn’t matter if different forex pairs have different values per pip of movement. It only depends upon the currency denomination of your trading account, but it is still a percentage of the core equity/account balance that we are risking and gaining reward on.
By only risking, say 0.50% on every trade, I know how much I am willing to lose on every trade and it doesn’t matter how many pips any trade is going to be. The way I was taught to do this is by measuring the size of the stop loss needed in pips. I then enter the pip amount into a Free Lot Size Calculator that then determines the Lot Size I should use for the trade with the dollar risk amount. If the trade goes against me and I get stopped out of the trade (I lose the trade), but I then know the exact amount of money I lose is 0.50% of my account.
You can get your Free Lot Size Calculator here and use it as it will become a valuable tool for your trading.
Conversely, because my trading plan is focused around a higher reward than risk, I know that my target is more pips than my stop loss pip amount, so I know that I am making a higher percentage return than my risk percentage.
I hope that’s not confusing for you and to make all the calculations easier for you, download the Free Lot Calculator and add it to your trading platform and use it every time you want to take a trade. A valuable tool to not only make your trading easier, but also make you trade correctly and safely by controlling risk by percentage and control your Money Management.
I also add here, that traders have their own opinion on how much percentage to risk from their accounts is acceptable. I prefer 0.50% per trade but others are happy to go as high as 5% per trade. Again, it all depends on each and every persons risk tolerance and also what the strategy or system is. I know that by using 0.50% of my account I can get many trades wrong and it won’t affect my balance very much and the risk of losing all of my account is very low.
Don’t worry though, in my early days I have blown up a few accounts (as they say in trading) and when I look back I now know it was because I didn’t fully understand about R:R, Win Ratios and Percentage Measuring of Account. All of these are part of Money Management and learning the right way is crucial to becoming a successful forex trader.
In Summary…
Money Management or MM as it is described in trading is a very critical part of trading. Learning and having a full understanding of what it means and how to implement it into your trading plan and psychology can only point your into the right direction of becoming a successful trader.
- Understand what Core Equity and Account Balance is and what they mean
- Understand what R:R is and means and how to use and implement it into your trading
- Understand what Win Rate is and means and how to use it correctly
- Measure your Stop Loss in percentage of your Core Equity/Account Balance and measure you success by percentage gains or losses
- Decide on how much percent of your account you should risk per trade. I use 0.50% but others use up to 5% of their account. Find something that suits your risk profile but my recommendation is on the lower end.
- Use the free Lot size calculator to manage your Money Management
With learning and understanding these five main points you will be heading in the right direction to becoming a successful profitable trader.
I hope my article was helpful and feel free to comment below or shoot me an email.
Happy Trading and regards
John
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