Money Management

Money Management Myths:

Myth 1: Traders should focus on pips.

You may have heard that you should concentrate on pips gained or lost instead of dollars gained or lost. The rationale behind this money management myth is that if you concentrate on pips instead of dollar you will somehow not become emotional about your trading because you will not be thinking about your trading account in monetary terms but rather as game of points. If this doesn’t sound ridiculous to you, it should. The whole point of trading and investing is to make money and you need to be consciously aware of how much money you have at risk on each and every trade so that the reality of the situation is effectively conveyed. Do you think business owners treat their quarterly profit and loss statements as a game of points that is somehow detached from the reality of making or losing real money? Of course not, when you think about it these terms it seems silly to treat your trading activities like a game. Trading should be treated as a business, because that’s what it is, if you want to be consistently profitable you need to treat each trade as a business transaction. Just as any business transaction has the possibility of risk and of reward, so does every trade you execute. The bottom line is that thinking about your trades in terms of pips and not dollars will effectively make trading seem less real and thus open the door for you treat it less seriously than you otherwise would.

From a Mathematical standpoint, thinking of trading in terms of “how many pips you lose or gain” is completely irrelevant. The problem is that each trader will trade a different position size, thus, we must define risk in terms of “Ddollars at risk or dollars gained”.  Just because you risk a large amount of pips, does not mean you are risking a large amount of your capital, such is the case that if you have a tight stop this does not mean your risking a small amount of capital.

Myth 2: Risking 1% or 2% on every trade is a good way to grow your account

This is one of the more common money management myths that you are likely to have heard. While it sounds good in theory, the reality is that the majority if retail forex traders are starting with a trading account that has $5,000 in it or less. So to believe that you will grow your account effectively and relatively quickly by risking 1% or 2% per trade is just silly. Say you lose 5 trades in a row, if you were risking 2% your account is now down to $4,519.60, now you are still risking 2% per trade, but that same 2% is now a smaller position size than it was when your account was at $5,000.

Thus, in the % risk model, as you lose trades you automatically reduce your position size. Which is not always the best course of action. There’s psychological evidence that suggests it’s human nature to become more risk averse after a series of losing trades and less risk averse after a series of winning trades, but that doesn’t mean the risk of any one trade becomes more or less simply because you lost or won on your previous trade. As we can see in my article on randomly distributed trading results, your previous trade’s results don’t mean anything for the outcome of your next trade.

What ends up happening when traders use the % risk model is that they start off good, they risk 1 or 2% on their first few trades, and maybe they even win them all. But once they begin to hit a string of losers, they realize that all of their gains have been wiped out and it is going to take them quite a long time just to make back the money they have lost. They then proceed to OVER-TRADE and take less than quality setups because they now realize how long it will take them just to get back to break even if they only risk 1% to 2% per trade.

So, while this method of money management will allow you to risk small amounts on each trade, and therefore theoretically limit your emotional trading mistakes, most people simply do not have the patience to risk 1 or 2% per trade on their relatively small trading accounts, it will eventually lead to over-trading which is about the worst thing you can do for your bottom line. It is also a difficult task to recover from a drawn down period. Remember, once you drawn down, using a 2 % per trade method, your risk each trade will be smaller, there fore, your rate of recovery on profits is slower and hinders the traders effort.

The Most important fact is this.. if you start with $10,000 , and drawn down to $5,000, using a fixed % method, it will take you “much longer” to recover because you started out risking 2% per trade which was $200, but at the $5,000 draw-down level, your only risking $100 per trade, so even if you have a good winning streak, your capital is recovering at “half the rate” it would using “fixed $ per trade risk.

Myth 3: Wider stops risk more money than smaller stops

Many traders erroneously believe that if they put a wider stop loss on their trade they will necessarily increase their risk. Similarly, many traders believe that by using a smaller stop loss they will necessarily decrease the risk on the trade. Traders that are holding these false beliefs are doing so because they do not understand the concept of Forex position sizing.

Position sizing is the concept of adjusting your position size or the number of lots you are trading, to meet your desired stop loss placement and risk size. For example, say you risk $200 per trade, with a 100 pip stop loss you would trade 2 mini-lots: $2 per pip x 100 pips = $200.

Now let’s you want to trade a pin bar forex strategy but the tail is exceptionally long but you would still like to place your stop above the high of the tail even though it will mean you have a 200 pip stop loss. You can still risk the same $200 on this trade, you just need to adjust your position size down to meet this wider stop loss, and you would adjust the position down to 1 mini-lot rather than 2. This means you can risk the same amount on every trade simply by adjusting your position size up or down to meet your desired stop loss width.

Let’s now look at an example of what can happen if you don’t practice position sizing effectively by failing to decrease the number of lots you are trading while increasing stop loss distance.

Example: Two traders risk the same amount of lots on the same trade setup. Forex Trader A risks 5 lots and has a stop loss of 50 pips, Trader B also risks 5 lots but has a stop loss of 200 pips because he or she believes there is an almost 100% chance that the trade will not go against him or her by 200 pips. The fault with this logic is that typically if a trade begins to go against you with increasing momentum, there theoretically is no limit to when it may stop. And we all know how strong the trends can be in the forex market. Trader A has gotten stopped out with his or her pre-determined risk amount of 5 lots x 50 pips which is a loss of $250. Trader B also got stopped out but his or her loss was much larger because they erroneously hoped that the trade would turn around before moving 200 pips against them. Trader B thus losses 5 lots x 200 pips, but their loss is now a whopping $1,000 instead of the $250 it could have been.

We can see from this example why the belief that just widening your stop loss on a trade is not an effective way to increase your trading account value, in fact it is just the opposite; a good way to quickly decrease your trading account value. The fundamental problem that afflicts traders who harbor this believe is a lack of understanding of the power of risk to reward and position sizing.

The Power of Risk to Reward

Professional traders like me and many others concentrate on risk to reward ratios, and not so much on over analyzing the markets or having unrealistically wide profit targets. This is because professional traders understand that trading is a game of probabilities and capital management. It begins with having a definable market edge, or a trading method that is proven to be at least slightly better than random at determining market direction. This edge for me has been price action analysis. The price action trading strategies that I teach and use can have an accuracy rate of upwards of 70-80% if they are used wisely and at the appropriate times.

The power of risk to reward comes in with its ability to effectively and consistently build trading accounts. We all hear the old axioms like “let your profits run” and “cut your losses early”, while these are well and fine, they don’t really provide any useful information for new traders to implement. The bottom line is that if you are trading with anything less than about $25,000, you are going to have to take profits at pre-determined intervals if you want to keep your sanity and your trading account growing. Entering trades with open profit targets typically doesn’t work for smaller traders because they end up never taking the profits until the market comes swinging back against them dramatically. (I think this is very important, go back an re read that last sentence)

If you know your strike rate is between 40-50% than you can consistently make money in the market by implementing simple risk to reward ratios. By learning to use well-defined price action setups to enter your trades you should able to win a higher percentage of your trades, assuming you TAKE profits.