Money Management Forex

Money Management In Forex Trading

Andrew Scaddon Education

Money management in forex trading is a bit like sex, all successful traders do it but they very often don’t talk about it. You will find lots of information on how to make money, but without proper risk control, you will lose.

Many traders have good methods but fail to pay attention to risk management and lose their equity. To win at forex trading, you need to play great offense when high odds trades present themselves and you need to combine this with great defense to preserve what you have.

Why money management?

As one famous trader once said:

“If you want to win, you need to bet and you can’t bet if you’re not at the table”
Larry Hite

This is an obvious statement but most traders simply think money management takes care of itself – it doesn’t. You need to defend what you have and when the odds are in your favor, take calculated risks to make profits.

Forex trading is risky and with the potential rewards it offers,  you would expect it to be. Risk is an inherent part of forex trading and that is why risk control is so important.

A good trader will aim to reduce risk with sensible money management techniques. Consider a high-performance racing car. Driving it at high speed is risky for a novice driver, yet in the hands of a skilled driver, the risk is reduced, as they have the technique and skills.

They, therefore, can drive the car at optimum speed without crashing to get from A to B safely. In this article, we will look at risk control and money management and how you can manage your account equity for bigger profits.

We are not going to confuse you with lots of mathematical equations and we’re not going to reiterate all the usual well-worn logic that includes:

Risking small amounts per trade or that diversification is the way to make money etc – it’s not. The majority opinion is not necessarily right – in the fact that the majority of forex traders who follow it lose or make marginal gains.

Here we want to look at how to take calculated risks at the right time which will help you enjoy long-term forex trading success.

Forex Trading and Risk

Forex trading involves risk, so let’s define exactly what the risk is and where it is:

If you trade currencies, you are immediately involved in risk management. There is the possibility of loss that is inherent in the nature of currency trading, that is, if we take a currency position we are immediately at risk. Note the next point!

The currency is not the risk, nor is the loss the risk – the possibility of loss is the risk. The only way to control the risk is to buy or sell the currency and the way you do this will ultimately determine your success as a currency trader.

In the business of trading currencies, and trying to make a profit, risk is always going to be present. It’s unavoidable and the best anyone can do is to manage it – but of course with risk – goes reward. Without risk, there cannot be the huge rewards available that are present in currency trading.

Savvy traders know the importance of risk management and there is a delicate balancing act to perform. If you risk little, you win little. If you risk too much, you will eventually blow your equity.

Your aim is to seek above-average profits by risking the optimum amount at the right time.

Basics of Risk and Money Management

Here are some more basic points you need to keep in mind when managing your equity and some basic facts about the market you are dealing with.

Always Assume the Worst

When you enter a trade always assume you are wrong first, anything else is then a bonus! There is NO Trade that doesn’t have the possibility of loss, don’t let anyone tell you otherwise.

Probabilities and Certainties

There are many people who will tell you that as human psychology is constant you can predict with accuracy what will happen next and predict where currencies will go.

This is rubbish – if markets could be predicted with scientific accuracy, we would all know the price in advance and there would be no market. The market price moves based on uncertainty and any trade you place has the risk of loss – that’s just the way it is.

Speculation VS Gambling

To win at forex trading you must understand the difference between speculating and gambling. Many people think they know the difference but they don’t.

The majority of currency traders think they’re speculating but are simply gambling and destined to lose. You can be a gambler or speculator at Blackjack or you can be a gambler or speculator in currencies – But what is the difference?

The difference is the odds of success when you play your hand or place your trade. As Peter Bernstein in his excellent book Against the Gods says:

“Games of chance must be distinguished from games in which skill makes a difference. The principles that work in roulette, dice, and slot machines are identical, but they explain only part of what is involved in poker, betting on the horses, and backgammon. With one group of games the outcome is determined by fate; with the other group, choice comes into play.

The odds– the probability of winning –are all you need to know for betting in a game of chance, but you need far more information to predict who will win and who will lose when the outcome depends on skill as well as luck. There are card players and racetrack bettors who are genuine professionals, but no one makes a successful profession out of Craps.”

If you can calculate and act on the odds, you can win – if you can’t calculate the odds, you will lose – it’s as simple as that.

In card-playing it is impossible to remove the house edge in a game such as craps, as you can never get the odds in your favor – it’s a game of pure luck.

On the other hand, if you play Blackjack correctly (we will return to this in greater detail in a moment) you can count the cards coming from the deck, calculate the odds, get an edge and win.

So in craps by the very nature of the game, you are always a gambler, in blackjack whether you are a gambler or a speculator, depends on the way you play.

In the currency markets, it’s the same scenario as blackjack – you can be a gambler or you can be a speculator – the choice is yours.

Most currency traders are gamblers, not speculators because they don’t know how to play the odds correctly in terms of knowing when to bet, how to bet and when to quit.

They could win but they choose not to, this is rooted in human nature as Bernstein says:

“Human beings have always been infatuated with gambling because it puts us head-to-head against the fates, with no holds barred. We enter this daunting battle because we are convinced that we have a powerful ally: Lady Luck will interpose herself between us and the fates (or the odds) to bring victory to our side.”

Of course, gambling long term doesn’t bring victory and over time you are destined to lose. The simple fact is – unless you understand how to use the odds to generate, trades and how to bet correctly you will lose.

Trading the Odds

Professional blackjack players tend to make excellent traders why? Because not only do they understand the odds, they understand the concept of folding, they know how to bet correctly and finally, they know how to vary bet size, when the odds are in their favor.

Dr. Edward Oakley Thorp graphically showed the concept of getting the odds in your favor when in 1962 he wrote his classic book – Beat the Dealer. This was the first book to prove mathematically, that blackjack could be beaten by card counting.

The technique eliminated the advantage of the house, which had an edge of approximately 5% and instead gave the player an advantage of around 1%. The fundamental principle behind counting cards in blackjack is that a deck of cards with a higher proportion of high cards (tens and aces) to low cards is good for the player.

On the other hand, the reverse is true for the dealer. You don’t need to know how to play blackjack to understand the concept, so don’t worry if you don’t know the game – we’re only looking at it from an odds scenario.

A card deck rich in tens and aces increases the player’s odds, because blackjacks (which offer a higher payout than other winning hands) become more common, the dealer is more likely to bust a stiff hand, and double-downs are more successful.

Card counters can, therefore, raise their bet size when the ratio of high cards to low cards in the deck is skewed in their favor. They also make strategy adjustments based on the ratio of high cards to low cards.

These adjustments to their betting and playing strategy can give players a mathematical advantage over the house and Thorp proved it. Thorp started his research using $10,000 funded by Manny Kimmel, a known mob associate.

The test proved successful and he won $11,000 in a weekend and could probably have won more if he had not alerted security in the casino and got ejected.

Can these principles of playing the odds be applied to financial markets?

The answer is a resounding yes. Thorp actually became a financial trader and enjoyed great success. Since the late 1960s, Thorp has used his knowledge of probability and statistics in the stock market by exploiting and trading, a number of pricing anomalies in financial markets to make long-term gains.

Princeton/Newport Partners was Thorp’s first hedge fund and recorded an annualized net return of 15.1 percent over 19 years.

In May 1998 Thorp reported that his personal investments have made an annualized 20% average return over 28.5 years. Thorp is not the only blackjack player to apply the skills of playing blackjack to financial markets.

Another famous blackjack player was Blair Hull and his interview in Market Wizards is well worth reading. Just like Thorpe, he moved effortlessly from playing blackjack to financial trading and made a huge fortune. In 1999 Goldman Sachs paid him $531 million for his company Hull Trading.

Hull’s first speculation, however, was a $500 stake he took to the blackjack tables of Nevada. In the early 1970s, he won enough from gambling to later pay $25,000 to work on the floor of the Pacific Stock Exchange (PSE), where he would become an options market maker.

Hull Trading approach was to look for short-term miss pricing in the options and equity markets and trade these high odds trades for profit and he did it with spectacular success making hundreds of millions of dollars.

Diversification and Risk

Diversification is seen as a great way to reduce risk in currency trading but all it does is dilute profit potential and you should resist the temptation. Furthermore, for most currency traders it’s not an option, as most are trading small accounts (by this I mean in $10 – 50,000 value) and they don’t have sufficient funds to diversify.

Keep in mind that with risk goes reward! If you risk 2% of your equity on a $10,000.00 account, that’s $200 and you won’t make much taking such a small risk. Loading The High Odds Trades If you want to win, you need to increase your bet size when the odds are in your favor.

Many traders always bet the same size but that is not the way to make spectacular gains. If you see the trade is a good high odds one and you have been making money – risk up to 10% of your equity.

Taking calculated risks at the RIGHT time, needs to be backed up by a reasonable size bet. There are many mathematicians who will show you lots of indicators like the Sharpe Ratio etc to show you risk – but for me and most other traders its great theory, but that’s all it is.

Same goes for the other well-worn topics like Modern Portfolio Theory – another great theory but what vital bit do these theories miss?

The trader and the part he plays in reducing risk. The maths and equations are great but I am interested in making money and that’s it. When I see a good trade, why should I take marginal or worse trade to balance my account that can dilute my profit potential?

The above is very much a personal opinion and other traders may disagree!

Your Account Objectives

How much money can you make annually, and do you have a target?

If you don’t, you should. My own view in light of the risks involved is you should aim at 50 – 100% per annum. If you aim for less there are other ways of making money with less risk – like investing in the property market. If you could make 100% you would be up there with the best traders and that’s a good figure to aim for in my view.

Most traders like to look at money management in terms of their betting size in terms of a simple percentage of equity. This is, of course, logical – but if you want to win you should vary your bet size and see money management in terms of the overall health of your account. For example:

The more you make on your core equity, the more you can risk. It’s easier to bet big using winnings rather than your initial stake.

If you suddenly have a big profit, regardless of what your system is telling you – bank it. Many small traders suddenly see their account size increase by 50% and hang on – my view is put it in the bank ( its half your annual target gain) and start again.

If you are doing badly and losing, make your bet size smaller and take your time. Your overall aim is to increase your core equity and get a cushion of profits. So, monitor these fluctuations carefully and above all, defend what you initially put up as your stake.

Varying bet size is logical and sensible and makes trading psychologically easier than looking at money management just in terms of risk per trade. Start with risk on your overall account and keep your overall profit target in mind.

High Odds and Low Odds Trades

The way you calculate your high odds trades is up to you. There are many different ways of making money and you should already have a system you are confident in – but here are some general pointers to keep in mind.

All trades are Equal In Terms Of Risk

This means that all trades have the potential to lose, and you should never fall in love with a trade and think it can’t. Many traders do and simply fall in love with a trade and like falling in love with a beautiful girl, the logic goes out the window and normally heartbreak follows!

There is no Rush

Always keep in mind that your Forex trading system will tell you when high odds trades are available. They can’t be hurried, you need to be patient and wait for them.

You don’t get paid for effort or how often you trade in Forex trading, you get paid for being right with your trading signal and that’s it.

Deciding Your Bet Size

“The guy who invented poker was bright, but the guy who invented the chip was a genius.”
Big Julie

The really successful blackjack and poker players always vary their bet size. They normally increase the bet based on how their overall account is performing and how they view their odds of success.

Varying bet size can make a huge difference to your overall account performance and if you bet big at the right time, it can make your account equity soar. Vary the size of the bet in light of the following points:

How The Account is performing overall. We looked at this earlier, and it makes it easier to take bigger bet sizes if your account is on the up and you’re risking profits. So what constitutes a high odds trade?

As we have mentioned previously, this is down to your Forex education and your Forex trading system. If you read our other materials, you will understand that the best set up for us is:

Investor Sentiment and Net Trader Speculative Positions At An Extreme

With both pointing in the opposite direction of the direction, we wish to execute our trading signal.

High Volatility

That is causing a blow of emotional high or low which has moved too far away from fair value.

Overbought or Oversold Momentum Indicators Diverging from Price

This involves RSI Being overbought and oversold on the indicator itself and in historical terms. A cross from an overbought or oversold area on the stochastic with bullish or bearish divergence is then used to initiate the trade.

Other traders may have other ways of doing it, it doesn’t matter – so long as you have checked your system, your methodology is sound and you have confidence and conviction in the trade.

Deciding your Stop Levels

On many occasions when you open a position, you are going to find it moves in the opposite direction to what you had anticipated. A ‘stop loss’ is simply a pre-defined level at which you will exit a position based on the premise that it is not moving in the direction that you had anticipated.

All experienced and successful traders will tell you that setting stop losses and sticking to them, is essential if you are going to be profitable over the long term and of course, it’s true – but how do you set them and what criteria do you use?

There are a number of different ways of determining suitable stop loss points and they all have their own strengths and weaknesses. There are also a number of different factors that will influence the way in which you determine your stop loss level including:

Your tolerance of risk, your systems methodology and the time frame you are trading. For example, a trader who trades over the short term will place their stop a lot closer to the price than another trader who trades over the medium to longer term. The trader looking longer term will place their stop loss further away from the price in order to allow the trend to move naturally.

They are looking for bigger profits per trade and therefore are prepared to risk a bit more. There are a number of different ways of selecting a stop loss point and the following methods are the most common:

Percentage of Equity

You can set your stop loss level based on losing a set percentage of equity they want to risk. For example, if you used a 10% stop loss, on a $10,000 account you would risk a $1,000.

An advantage of using a percentage initial stop loss is clear – it is easy to calculate and use. A disadvantage is that it doesn’t tailor the position of your initial stop loss to the volatility (risk profile) of the currency pair.

In other words, if currency pair A was twice as volatile as currency pair B and you used a 10% initial stop loss with both trades, then your stop loss with A is ‘closer’, because it is more volatile and the 10% is not as far away based on currency pair B in terms of market behaviour.

This method has its limitations and I have not used this method often but know traders who swear by it. It is easy to understand and apply and keeps money management straightforward and simple with no subjective judgment needed.

Technical Levels

You can set your stop loss level using technical analysis and this is the most popular and most effective way of doing it in my view. For example, you can determine at what point on the chart you will change your opinion on the likely direction of the currency trend in line with important levels of support and resistance.

There are theoretically an infinite number of potential exits points based upon using technical analysis but simple support and resistance is our preferred method.

Moving Averages

Another way popular with many traders is using a simple moving average. The moving average is ideally positioned to be used as a technical stop. As the price moves higher and the moving average lags behind, it continues to be well positioned to be used as a technical stop, in that should the price trade and close below the moving average, that would be the exit point.

Using technical stops is probably the most effective way of determining suitable initial stop loss points. You do however need to be careful that you don’t get to subjective in terms of applying your indicators and stay objective.

Our trading is based on extremes and breakouts and the stop levels are crystal clear where they should be in advance i.e. behind the breakout point or behind a market high or low.

Volatility

You can set your stop loss level based on the normal trading behavior. For this, you need to have a good understanding of Standard Deviation of the price.

You can look up standard deviation or read about it in our other material but we are not great fans of placing a stop based just on volatility only – but many traders like to do it so if you do you can learn more in the video section of this site.

Even if you do not set stops based on pure volatility you still need to take into account the potential volatility of the market so you don’t get stopped out by it.

This is something a day trader never learns – All daily volatility is random, so over time they’re bound to lose as their stops are going to get hit as volatility in a day can, and does take prices anywhere.

Note: If you think that you are going to be stopped on volatility or that you want to gain staying power in the short term, then options are a good vehicle for novice traders.

They will give you the peace of mind of unlimited profit potential combined with limited risk – it doesn’t matter how far the market travels down or up away from your entry, your risk is your premium and that’s it.

Of course, to make money, your position must trade in the money before expiry – but options are a great vehicle for novice traders.

Trailing Stops and Taking Profits

Trail a stop too close and you will get stopped out before the trend has run its course – trail it too far away and you give back profits. This is the hard part for many traders!

What you have to accept is that you are never going to buy the top or sell the bottom, and you can always wonder what might have been. However, remember you’re not after perfection; you’re simply after a profit.

Tips on Trailing Stops

Here are some tips on trailing stops and the way you trail stops or take profits will depend on the type of trader you are.

For Longer Term Trend Followers

Use significant support and resistance to define the stop area. When the trend first gets underway – do not move too quickly, keep your stop back and then start to trail once the trend is well away from where you entered it. Use support and resistance, and in a strong trend, the mid-Bollinger Band (moving average) will also provide support so use the two together.

You can use a profit target on long-term trends but they tend to go on for a lot longer than most traders think and it’s in most instances better simply to trail.

You have to accept that you are going to give back a big chunk of the trend at some point but as no one knows when a trend is likely to turn, this is just part of trend following. Keep in mind the best trend follower only catch 50 – 60% of the major trends, so if you do too, then you will be very successful.

For Swing Traders

Here, it’s a good idea to work with a target if you’re after smaller profits, as they can disappear quickly. So, use a target and get out earlier than the herd. If you hang on too long in swing trading, you will give a lot or all of your profit back.

Final Words

“Risks must be taken because the greatest hazard in life is to risk nothing.”
Leo F. Buscaglia

If you want to make money in anything – you have to take a risk. In currency trading, as soon as you enter a trade you’re at risk, and the way you deal with the risk will determine whether you will be a winner or a loser.

Risk is not something to fear, it is something to see in a positive light because it’s necessary for any venture to make money, and forex trading, of course, is no exception.

When you operate in forex markets, you are operating in a world where only you can be wrong and the market price is always right no matter what you think.

You will lose for sure at times but if you know how to trade the odds, and have a plan to control and manage risk, you can emerge a winner.

Further Reading

These books are essential reading for any trader.

Against the Gods: The Remarkable Story of Risk by Peter L. Bernstein

This book is a narrative that reads like a novel and is simply essential reading for anyone involved in trading or just likes a good intellectual story – over 400 pages of essential info. The book shows how risk management liberated humanity from the oracles and soothsayers to take charge of our destiny and give us choices instead of relying on the gods and fate. This is a great read featuring Greek philosophers, Arab mathematician’s scientists, gamblers, philosophers, world-renowned intellects and inspired amateurs – fantastic stuff!

The Intelligent Investor: A Book of Practical Counsel by Benjamin Graham

The classic bestseller by Benjamin Graham, perhaps the greatest investment advisor of the 20th century, The Intelligent Investor has taught and inspired investors worldwide and covers all areas an investor needs as part of his investment strategy including good advice on risk-taking.

What I Learned Losing a Million Dollars by Jim Paul, Brendan Moynihan

One of the best books on risk and risk management you are ever likely to find. The book presents a serious psychological analysis of a trader and explains the three biggest mistakes made by traders investors, how to avoid them, which pattern all losses take, and why the most important factor in trading successfully is not losing.

If you didn’t think you could learn anything from someone who wiped themselves out then this book will change your view.

The Zurich Axioms by Max Gunther

This is an unconventional book, and much of its advice flies in the face of common investment wisdom. It’s one of those books you can’t put down and will have you smiling, inspired and ready to love risk!

Way of the Turtle by Curtis Faith

In just 14 days trading legend took a group of traders who had never traded before and set them on the road to making hundreds of millions of dollars. Curtis Faith was one of these groups and the most successful.

In this book, he reveals the methods they were taught and how he and the others applied them. A major component you would expect of their success was their risk control and money management techniques.

Market Wizards: Interviews with Top Traders by Jack D. Schwager

Classic bestseller which gives a unique opportunity to share with some of the world’s top traders, their trading methods and strategies and to understand their “mindset” and the factors that turns them from losers to exceptional winners. All the interviews are good and all discuss risk control and money management and the interview with Blair Hull is excellent.