Money management is a critical point that shows the difference between winners and losers. It was proved that if 100 traders start trading using a system with 60% winning odds, only 5 traders will be in profit at the end of the year. Despite the 60% winning odds, 95% of traders will lose because of their poor money management. Money management is the most significant part of any trading system. Most traders don't understand how important it is.
It's important to understand the concept of money management and understand the difference between it and trading decisions. Money management represents the amount of money you are going to put into one trade and the risk you are going to accept for this trade.
There are different money management strategies. They all aim at preserving your balance from high-risk exposure.
First of all, you should understand the following term Equity.
Equity = Starting balance - Amount in open positions.
If you have a balance of 10,000$ and you enter a trade with 1,000$ then your core equity is 9,000$. If you enter another 1,000$ trade, your equity will be 8,000$
It's important to understand what's meant by core equity since your money management will depend on this equity.
We will explain here one model of money management that has proved high annual return and limited risk. The standard account that we will be discussing is a 100,000$ account with 20:1 leverage. Anyway, you can adapt this strategy to fit smaller or bigger trading accounts.
Your risk per trade should never exceed 3% per trade. It's better to adjust your risk to 1% or 2%
We prefer a risk of 1% but if you are confident in your trading system then you can lever your risk up to 3%
1% risk of a 100,000$ account = 1,000$
You should adjust your stop loss so that you never lose more than 1,000$ per single trade.
If you are a short-term trader and you place your stop loss 50 pips below/above your entry point.
50 pips = 1,000$
1 pips = 20$
The size of your trade should be adjusted so that you risk 20$/pip. With 20:1 leverage, your trade size will be 200,000$
If the trade is stopped, you will lose 1,000$ which is 1% of your balance.
This trade will require 10,000$ = 10% of your balance.
If you are a long-term trader and you place your stop loss 200 pips below/above your entry point.
200 pips = 1,000$
1 pip = 5$
The size of your trade should be adjusted so that you risk 5$/pip. With 20:1 leverage, your trade size will be 50,000$
If the trade is stopped, you will lose 1,000$ which is 1% of your balance.
This trade will require 2,500$ = 2.5% of your balance.
This's just an example. Your trading balance and leverage provided by your broker may differ from this formula. The most important is to stick to the 1% risk rule. Never risk too much in one trade. It's a fatal mistake when a trader loses 2 or 3 trades in a row, then he will be confident that his next trade will be winning and he may add more money to this trade. This's how you can blow up your account in a short time! A disciplined trader should never let his emotions and greed control his decisions.
Trading one currency pair will generate few entry signals. It would be better to diversify your trades between several currencies. If you have 100,000$ balance and you have an open position with 10,000$ then your core equity is 90,000$. If you want to enter a second position then you should calculate a 1% risk of your core equity not of your starting balance. This means that the second trade risk should never be more than 900$. If you want to enter 3rd position and your core equity is 80,000$ then the risk per 3rd trade should not exceed 800$
You must diversify your orders between currencies that have low correlation.
For example, If you have a long EUR/USD then you shouldn't long GBP/USD since they have a high correlation. If you have long EUR/USD and GBP/USD positions and risking 3% per trade then your risk is 6% since the trades will tend to end in the same direction.
If you want to trade both EUR/USD and GBP/USD and your standard position size from your money management is 10,000$ (1% risk rule) then you can trade 5,000$ EUR/USD and 5,000$ GBP/USD. In this way, you will be risking 0.5% on each position.
It's very important to understand these 2 strategies.
Martingale rule = increasing your risk when losing!
This's a strategy adopted by gamblers which claims that you should increase the size of your trades when losing. It's applied in gambling in the following way Bet 10$, if you lose bet 20$, if you lose bet 40$, if you lose bet 80$, if you lose bet 160$..etc
This strategy assumes that after 4 or 5 losing trades, your chance to win is bigger so you should add more money to recover your loss! The truth is that the odds are the same despite your previous loss! If you have 5 losses in a row, still your odds for the 6th bet 50:50! The same fatal mistake can be made by some novice traders. For example,if a trader started with n balance of 10,000$ and after 4 losing trades (each is 1,000$) his balance is 6000$. The trader will think that he has higher chance of winning the 5th trade then he will increase the size of his position 4 times to recover his loss. If he loses, his balance will be 2,000$!! He will never recover from 2,000$ to his starting balance 10,000$. A disciplined trader should never use such a gambling method unless he wants to lose his money in a short time.
The anti-martingale rule = increase your risk when winning& decrease your risk when losing
It means that the trader should adjust the size of his positions according to his new gains or losses.
Example: Trader A starts with a balance of 10,000$. His standard trade size is 1,000$
After 6 months,his balance is 15,000$. He should adjust his trade size to 1,500$
Trader B starts with 10,000$.His standard trade size is 1,000$
After 6 months his balance is 8,000$. He should adjust his trade size to 800$
This strategy is for traders looking for higher returns and still preserving their starting balance.
According to your money management rules, you should be risking 1% of your balance. If you start with 10,000$ and your trade size is 1,000$ (Risk 1%) After 1 year,your balance is 15,000$. Now you have your initial balance + 5,000$ profit. You can increase your potential profit by risking more from this profit while restricting your initial balance risk to 1%. For example, you can calculate your trade in the following pattern:
1% risk 10,000$ (initial balance)+ 5% of 5,000$ (profit)
In this way you will have more potential for higher returns and at the same time, you are still risking 1% of your initial deposit.
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