So far in this series about building a solid trading system we’ve identified the mechanics of your trading system. By that I mean… when you are going to trade, what time frame to trade, when to get into the market, where to put your initial stop loss and take profit and how you are going to manage the trade after it is placed. Now it is time to talk a little about the most important part of any trading system… money management.
Your money management strategy can mean the difference between success and failure.
If I gave the exact same trading system rules (without money management), to two different traders, each trader would get very different results. It is possible for one trader to be extremely profitable while the other blows out their account. The difference is the money management strategy they use. This is why money management is the most important aspect of your trading system.
Money management is basically RISK management. A novice way of looking at trading is to focus on how much money you can make. A more professional approach is to focus on how much money you can lose. In my opinion, it is best to lower your earning expectations and focus on losing less money.
So, how much money do your risk on each trade? At the end of the day, you need to figure out the lot size you are going to use when you get into the markets. There is a lot to consider when making this decision.
Money Management Considerations
Your Account Balance:
Traders seem to take a different approach to money management depending on the size of their trading account. Traders with small accounts tend to be aggressive, and traders with large accounts tend to be conservative. (My advice is to adopt a money management strategy you would feel comfortable trading on a large account, regardless of your starting account size).
The Stop Loss Size:
Your stop loss determines the number of pips you are willing to risk on the trade. This value is used to determine what lot size you can use per pip that fits with your risk strategy. For example, if you only want to risk $200 and use a 20 pip stop, each pip can have the value of $10.
The Take Profit Size:
The relationship between what you are willing to risk to what you hope to gain is your risk to reward ratio. A good overall strategy needs to take these two values in consideration (stop loss size and take profit size), to ensure a positive starting risk to reward.
How Many Trades You Place At One Time:
If you are taking more than one trade at a time, this needs to be factored into your overall strategy. You need to figure out the money management for each trade while taking the maximum number of trades that can be placed at one time. For example, if you want to use 2% of your balance per trade and take 5 trades at a time… you really are risking 10% of your account at any one time.
Different currency pairs have different pip values. It is not always the case where 0.01 lots equals $0.10, 0.1 lots equals $1 and 1.0 lots equals $10.
Your Risk Tolerance:
Obviously, this is a personal choice. Some people can handle more risk than others. You need to align your money management strategy with your trading personality. Only a good fit between your risk management and your personality will stand the test of time.
4 Common Money Management Strategies
Here are 4 pretty straight forward risk management strategies…
You simply decide on a fixed lot size for each trade, like 0.02 lots per trade. While this is the simplest of all methods, it does have its problems. For example, depending on the stop loss size used, the risk is different per trade. (A trade with a 20 pip stop loss risks substantially less than a trade with a 80 pip stop loss).
If you were to use use Fixed Lots, it is a good idea to use a very conservative setting. If you use too high a lot size, you can easily get into trouble when you hit a losing streak.
Fixed Dollar Amount:
You could determine a dollar amount you feel comfortable risking for each trade. For example you could risk $100 per trade, if your account balance permitted. Depending on the stop loss size, you would have to figure out the lot size that corresponds to $100.
This method helps emotionally. If you choose a dollar amount that does not produce too much stress, each trade is the same in terms of potential loss. One trade does not take on more importance than another.
X Lots Per Y Balance:
You could decide to use a certain lot size per dollar amount in your account. For example, you could say you want to use 0.01 lots per $1000 in your account. In this way, the lots size increases as your account balance increases. When your account reaches $2000, you would start trading 0.02 lots.
You need to take into account your starting balance, typical stop loss sizes, how many trades you take at one time, etc. to make sure you are not risking too much of your account at any one time. Don’t jump into using a strategy like this without taking into account the worst case scenario… where you loss every trade placed on any given day, or hit a losing streak.
Fixed Percentage Per Trade:
This is where you decide on a percentage per trade you are willing to risk. For example, you could say you want to risk 2% per trade. You take 2% of your account balance and divide it by your stop loss to figure out the lot size per pip you can use per trade.
This approach is popular with pro traders because each trade has the same value proportionally, independent of the stop loss used. A trade with a stop loss of 20 pips is the same as a trade with 200 pips in terms of percentage of account at risk. Plus as your balance increases, so does your lot sizes and potential profits.
Money management is a big topic, and this is getting long. I think I’m going to have to do another post to touch on other aspects and the importance of this topic. I know trading strategy entries are more exciting, but it is the “boring” topic of money management that can mean all the difference to your trading system’s success.
If you have a favorite money management strategy or something to add, please leave a comment and share it. What money management strategy works best with your trading personality?