STRATEGY #4: Money Management

STRATEGY #4: Money Management Money management is at the same time the guardian or the thief of your capital. 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 $5,000 account. Therefore your margin is $5,000. 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 $50,000). You have probably confidence due to the fact that your leverage is 1:100 so only $500 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 $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 $10). This amounts to 5% of your initial capital. Now you margin is $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 $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 $8,500 margin, you need an almost impossible 17.65% gain to recover. 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. 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.