When I ran away from Singapore, they started to understand that something was wrong. The main reason for the bank collapse was its poor money management system.
Nick Leeson. 10.11.2007, Moscow.
Dear friends, last time we discussed the necessity to put stop orders, one of the main tools for limiting losses. Today, I would like to touch the issue of money management and look at it in detail. Besides, we should decide whether the system is useful for forex trading. Let’s start from the definition.
Money management is a set of rules and techniques that allows traders and investors to minimize possible losses and get the biggest income.
Risk per order/ a series of orders is the largest loss that you decide to have opening a particular position or several positions.
In my opinion, it is impossible to become a successful trader without good knowledge in money management. Like most newbies I started my trading career from learning peculiarities of the MT4 trading platform and forecasting price movements. I was trading various instruments without following any approach. Besides, I was unaware of limiting losses. Of course, I knew how to put stop orders, but I simply did not want to fix losses. In an attempt to get profit of a couple of pips I often suffered losses of 200-300 pips. When a particular price did not come back, I reached margin call (a situation when you do not have enough money on your account for trading). After another lost deposit I decided to learn to manage trading funds.
You can choose one of the money management methods that will suit your trading system.
1. Fixed risk on a deal
According to this trading system, you should use stop orders. Profit can be fixed by the market, take profit, or trailing stop. You should open a deal after the trading system gives you a signal. A stop order can be either dynamic or fixed. If you choose a conservative approach, risk per order will be 1% from free funds. In case you prefer moderate trading, the risk will amount to 2%, and in case of aggressive trading, 5%. Let’s choose a risk of 2%.
To calculate a lot size that you need to enter the market, you should know a pip price for a particular trading instrument. For example, InstaForex offers Trader Calculator. Let’s take EUR/USD, the most liquid pair. In the Volume field type figure 1, thus, one pip (a four-digit figure) costs $1.
Now, let’s calculate the stop loss size. For example, the current price of the EUR/USD pair is 1.3423. According to the trading system, there is a buy signal and stop loss is set at the level of 1.3373.
Stop loss = (1.3423 – 1.3373)*10,000 + 3 pips (spread) = 53 pips
Now you can calculate risk per order in the currency of your deposit and a deal size to enter the market as you have the following figures:
Risk per order – 2%
Balance - $1,000
Pip price - $1
Stop loss size – 53 pips
Thus, you have the following calculations:
$1,000/100*2 = 20$ // money that you risk opening a deal
$20/(53*1) = 0.37 (lots)// deal size
2. Fixed risk on several deals
According to your trading system, you open a series of deals with the difference of several pips and with one stop order.
Let’s look at the example of three simultaneous deals.
Risk per order for every deal is 2%, thus, risk per a series of deals is 6%. Besides, the size of the next deal will increase.
Let’s calculate a size for every deal:
$1,000/100*2 = 20$ // money that we risk in every deal
Stop loss_1 = (1.3524-1.3417)*10,000+3 = 110 pips
buy_1 = 20/(110*1) = 0.18 (lots)
Stop loss_2 = (1.3487-1.3417)*10,000+3 = 73 pips
buy_2 = 20/(73*1) = 0.27 (lots)
Stop loss_3 = (1.3467-1.3417)*10,000+3 = 53 pips
buy_3 = 20/(53*1) = 0.37 (lots)
If you would like to use a 2% risk for a series of deals, then a risk per order will be 2%/3= 0.66%.
At first you may think that the calculations are difficult, but after some time you will need only 5 seconds to know a deal size. A combination of positive mathematical expectation and money management will help you both save your deposit and gain money.
In the next articles we will tackle such types of money management as a method of fixed proportion, martingale, and pyramiding.