This is achieved by managing factors such as the amount of capital risked per trade and the total number of open positions. This ultimately ensures a trader can withstand losses within his or her trading system without “running down” the account.
Forex trading makes this task particularly challenging. Firstly, many forex traders use high leverage. This means if a trader’s money management isn’t sound, small movements in the market can have dramatic effects on the floating P&L.
If a trader’s money management isn’t sound, small movements in the market can have dramatic effects on the floating P&L.
Secondly, the forex market uses fixed-sized trading contracts known as lots. With a smaller account, this makes the choice of trade size even more critical since each unit can represent a relatively large proportion of the account capital.
1. Risk Per Trade
The first principle of money management involves deciding how much of your total capital to expose at any given time. All things being equal, the more of your capital you expose (trade with), the more risk you are taking.
Your market exposure is a combination of:
a) The amount of capital allocated per trade
b) The number of open positions you are holding
More capital exposed = higher risk, potentially higher profit
Less capital exposed = lower risk, potentially lower profit
If you choose too small a value, your account will be underutilized. Too large a value and you risk a margin call. So what’s the best way to go?
Fractional money management
Many traders use formulaic approaches based on ideas such as “fixed ratio” or “fixed fractional” money management.
The advantage of using a formulaic approach is that it will tell you precisely how many lots to trade at any given point. In doing so it takes into consideration the account balance, lot size and the maximum loss allowed per trade.
As your balance changes through profits or losses, your exposure is increased or reduced in the same proportion. See Figure 1.
So let’s say you have a nano account size of $1,000. If your stop loss is 100 pips, and you want to risk no more than 1% per trade that would mean you can trade 10 lots each. And your maximum exposure per trade is $10. If you use 10 lots per trade, that’s 1% of your capital at risk on each open position. See the table below.
|Lot size (in standard lots)||0.001|
|Max stop loss (pips)||100.00|
|Max risk per trade||1.00%|
|Max risk on account||15.00%|
|Max permitted loss per trade||$10.0|
|Max account loss||$150.0|
|Max lots per trade||10.00|
|Max open lots||150.00|
The Excel spreadsheet that can be downloaded below will calculate the sizes and maximum lots using fractional money management.
We also have a Metatrader money management indicator that will do the calculations for you “on the fly”.
One thing the above doesn’t do is factor for correlation between positions being held. For that you will need to calculate the VAR – or value at risk.
Advantages of smaller lot sizes
When it comes to money management, flexibility is the key. Having an account that’s able to trade in smaller lots has several major advantages.
Firstly, you can split trades into smaller sized units and this allows you to manage risk more effectively. It also gives you more leeway to adjust trade sizes in line with accumulated profit/loss as the account balance changes.
Secondly it allows you to stagger your entry and exit points. This means you reduce the risk of being taken out in one sweep by a sudden increase in spreads or volatility. Several trading strategies such as Martingale and grid trading use this approach.
You can see by checking the spreadsheet that with a balance of $1,000 you shouldn’t risk more than 1 micro lot per trade. If you have a balance of $100 then you’d really need to use a nano account in order to keep within advisable risk limits.
Beware of correlations
Once you’ve decided how much to risk per trade, the next question is “how many open lots (positions) to allow at any given time?”.
Currency pairs tend to move in unison with one another more than other asset types such as stocks. That is, they’re strongly correlated either directly or indirectly. If you’re trading the majors, all of your positions are likely to be correlated with one another – at least to some extent.
It’s important to check both the historical and current correlations between the pairs you are trading. If you use Metatrader you can use our free hedging indicator to do this for you.
This correlation needs to be factored in when deciding your overall account exposure. If you allow too many open lots on correlated pairs, you can find your account balance is adversely affected by the movements of just one or two of them.
Just because a system has a higher payoff verses loss, doesn’t necessarily make it a good system.
2. Risk Reward
The second aspect of money management is the concept of risk vs. reward. On an individual trade, the risk is the potential loss in the transaction. The reward is the potential gain.
However, this is only part of the story. The other side of this is the outcome – that is the odds of winning verses losing.
For example, a trader may be willing to risk a greater loss, if the probability of that loss occurring is small. Likewise, a trader may be willing to accept a smaller reward, if the odds of winning are in his favor.
In spite of what many people think, having a reward value that’s less than the risk is not necessarily a bad strategy. Likewise, just because a system has a higher payoff verses loss, doesn’t necessarily make it a good system. If it were so simple to load the odds in your favor by adjusting risk:reward then wouldn’t trading be a simple task? Unfortunately things are never that easy.
There are several factors that need to be considered.
Firstly, suppose you have a much lower risk verses reward. That is you set your trades with a stop loss that’s much smaller than your take profit amount. Suppose you use a 10 pip stop verses a 100 pip take profit.
If you believe the markets are efficient, then this implies that all information is reflected in the existing price. We shouldn’t therefore be able to beat the market consistently. The outcome of any trade would then be at best 50:50. I’m ignoring any carry opportunity and trading costs here.
p(win) x win + p(loss) x loss = 0
P(win):p(loss) = -loss: win
In other words, the risk-reward ratio is exactly the inverse of the odds of winning verses losing. For example, if your risk-reward is 3:1, then your odds of winning must be 1:3.
That is with a 3:1 risk-reward, you risk 300 pips to gain 100 pips. Then, if the market is efficient your odds of success must be exactly 3 times your odds of losing. (read more here)
Of course this doesn’t mean the outcome of every trade is zero, and it doesn’t mean there aren’t long term winning and losing runs in the markets. Statistical outliers do exist; ask Warren Buffet or George Soros.
In this case, statistically speaking fewer of your trades will end in profit. This will give you a lower overall trade win ratio. However, when you win, the payoff will be significant compared to the smaller losses.
Now on the other hand, suppose you do it the other way around. You set wide stop losses at 100 pips, and a small take profit of just 10 pips. In this case, you’d expect to have a much higher win ratio.
When you use this type of setup, while the losses may be fewer, any individual loss may be unmanageable within the account.
Strike a balance between your risk/reward
In a nutshell, there is no right “risk-reward” ratio. The level you use will depend on your strategy and your trading objectives.
Keep in mind that high risk strategies demand extraordinarily high trade win-ratios. And that is extremely difficult to maintain in the long run. If your loss per trade is too high, you may discover that a relatively short sequence of losing trades is enough to take you out.
In forex, “unlikely events” tend to happen much more often than people realize. Traders who follow good money management are wise to this and are prepared; those who don’t end up getting wiped out.
Why Do So Many Traders Fail?
If the efficient market principle is correct, it would mean a trader’s returns should be near break-even over the long term. Yet studies show most traders (at least retail traders) fare far worse than this. So how can this be?
I can think of a few reasons why this might be the case:
Reason 1: Information disadvantage
The first possible explanation is that market makers and institutional traders are privy to insider information. They have insight into order flows, of speculative money, as well as rumors about activity in other markets like options, M&A, and the debt markets – which can all have significant short term influences on exchange rates.
This means they’re better able to assess the direction of price action – at least in the short term. This puts them at a distinct advantage to retail traders who don’t have access to this information.
Not only that, institutional traders amost always get better price execution than retail traders who often have several layers of broker-dealers between them and the market place.
Reason 2: Over leverage
Using excessive leverage is the most common reason that retail traders “lose their shirts” in the market. The levels of leverage that are available in the retail FX world are simply never used by professional players, for good reason. All trader’s real return on equity will vary plus or minus a few percentage points over any period. The more you amplify those return swings with leverage, the greater the probability of being obliterated by one big drawdown.
Reason 3: Trading costs
The other big reason is trading costs. Trading costs actually cut into profits far more than many people realize.
If your take-profit value is too small, you will find a significant proportion of your overall profits are absorbed by the spread. If you’re a scalper for example, targeting a 10 pip profit per trade, then about half of your overall profits could be taken up by trading costs.
On the other hand, if you’re a long term position trader, who targets 500 pips per trade, your trading costs only represent 1% of your profits. See the table below.
|Take profit level (pips)||10||20||100||150||500|
|Cost of spread (5 pips)||50.0%||25.0%||5.0%||3.3%||1.0%|
Research shows that most newcommers trade intra-day. So their costs are significant in comparison to their profits. In the short term at least, the odds favor the market maker (and your broker) due to trading fees.
As well as the trade spread, traders who hold overnight positions also have to pay a rollover fee. And with brokers charging rates of between 0.14% and 7.2% pa on a lot, this can add up to a huge amount over time – especially when using high leverage.
Reason 4: Too short a time horizon
New traders usually have an expectation to see results very quickly. It’s unrealistic to measure any trading strategy over a period of days or weeks. Doing this can lead you to conclude that profits are much better or worse than they really are.
Performance needs to be averaged at least over several months, if not years. Unfortunately many new traders are so highly leveraged that they literally cannot afford any losses and often capitulate out of their strategy at the worst possible time.
While reason #1 may have some weight, for most traders the last three points are probably far more influential.
The good news is that most of the above causes of failure are very easily remedied:
- Go easy on leverage
- Minimize your trading costs &
- Have a realistic trading plan
By doing this you’ll be ahead of 95% of the crowd.