Money Management

Money management is at the same time the guardian or the thief of your capital you decide.

The problem is that it is not always a conscious decision, subliminal impulses fueled by greed and fear makes us decide wrong and whenever we realize it, it’s too late. Several works have demonstrate the futility of taking huge risks, this approach of “getting rich overnight” will results always in big loses. And if once it does result in profit, further greed-fueled risk taking behavior will transform it in a big loss for sure. Let’s see an example of bad money management:

You decide to open a forex trade: You have a US$10,000 account. Therefore your margin is US$10,000. You decide to trade the EUR/USD pair. You are convinced that there is a big LONG trend developing.

FIRST ERROR: Never be convinced, at the most, you may think that the odds are with you, always approach this as if you are already losing a predetermined amount of money, for it will happen more than once for sure. Therefore, make sure that you don’t risk a big amount.

Now you enter a LONG position (i.e. buy the EUR/USD pair hoping for it to increase). You buy 1 standard Lot of EUR/USD (you are buying a lot of this pair for the equivalent of US$100,000). You have probably confidence due to the fact that your leverage is 1:100 so only $1000 from this money is really yours.

SECOND ERROR: Leverage is very appealing, the possibility of making money with the money of other persons, and multiplying your profit x100, x200, even x400. Remember, also the risk is yours, and it is multiplied by the same factor. You will be accountable for all the loss, not your broker, the house never loses.

Your instructions to the broker are to close your long position when there is a loss of 50 pip (stop loss order) or when there is a profit of 100 pip (take profit order).

THIS IS THE THIRD ERROR: You have produced a lethal combination of a big betting (1 lot is on the verge of being too large for a US$10,000 margin) with a huge greed (100 pip profit is too ambitious when you are already on the limit of trading size. This happens because your large expected profit determines also the relaxed stop loss order: a huge 50 pip, as you will see below.

And now it happens that you were wrong and indeed the EUR/USD pair moved against you in a Short trend, you hit the stop loss and you lost 50 pip. This is translated into US$500 loss (50 pips mutiplied by the pip value that for 1 standard lot is US$10). This amounts to 5% of your initial capital. Now you margin is US$9,500. In order to recover from this loss you need a gain of 5.26%, not of only 5%. And this is only to break even. And again if you have a setback with the same strategy, another 50 pip loss drives you to a US$9,000 margin.

To recover you will need an 11.11% gain which is a lot more difficult. Your margin is in its way to extinction. A third loss will take you to a new low of US$8,500 margin, you need an almost impossible 17.65% gain to recover.

A fourth loss will drive your margin to US$8,000. I don’t have to tell you what a new loss will mean, you imagine. The problem is that having no more margin (or a too small margin), precludes any possibility of making a comeback. Statistically this does not happen. Now lets say that after the fourth loss-in-row, you have a good trade and you earn 100 pips=US$1,000. Your margin rises to US$9,000. You feel happy. If you examine it again and are objective there is no reason to be happy, you have worked a lot, you have been over several hours and days of stress, have lost time that you took from your family, work, personal leisure and friends, and you have still a net loss of US$1,000. A new good trade will lead you to US$10,000. You are only in your starting line.

MAKE NO MISTAKE ABOUT THIS: Losses-in-row are common, they happen, when they happen they may destroy your margin. You better work in any other activity instead of pressing the gas in when the gear is in neutral.

Should the drawdown continue to 10 consecutive loses your margin will be reduced to US$5000, and it will drag your self-confidence down as well.

Now let’s see an example of good money management: Same margin US$10,000. You decide to go long on USD/EUR with 0.5 lots, stop loss=20 pip, take profit=50 pip. You make four bad trades in a row. Every bad trade results in US$100 loss (20 pips multiplied by the pip value that for 0.5 standard lots is US$5). You lost 1% of your margin in every lost trade. Your accumulated loss after four-in-row loses is already 4% of your margin or US$400, so your new margin is USD$9,600. You need a 4.16% increase to recover.

Not impossible. Odds are that you will have good trades also, but you need to leave margin, to protect it from the losses-in-row (called also drawdown). One good trade with this money management will give you a profit of 50pip=US$250. A second one is another US$250. Your margin is already US$10,100, in blue. You were never too far from your initial margin, you survived the drawdown. And even if the drawdown had continued, it will not take you too far from your original margin. A drawdown of 10 consecutive loses will take you to a margin of US$9,000 (with the bad strategy only 2 losses-in-row will be enough to reduce your margin to US$9,000).

Take a look at the characteristics of good money management: Trade risk spans between 1-1.5% of the margin, not more. This means that a single trade risk may be between 1-1.5%, but if you have simultaneous trades the overall risk should be 1-1.5%. The risk is directly proportional to the number of lots you trade and to the number of pips you risk (stop loss). Since you want to have profit and not only to be in even position after a loss, your take profit order should be 2-2.5 times the stop loss order.

In summary: when being hit, minimize injuries, when you hit, HIT HARD.