Forex Money Management Essentials

Despite the fact that this key trading essential—risk management—is oft-overlooked, Adam Lemon, of DailyForex.com, stresses its importance and outlines why it should actually serve as the cornerstone of every forex trading strategy.

Money management is usually the most important X-factor that determines the overall profit or loss of forex trading strategies. This is so frequently overlooked that it needs to be said over and over again. It is one of the key trading essentials. Money management in itself won’t give you a winning edge—you need good trade entry and exit strategies for that—but without intelligent money management practices, a winning edge will not see its full profit potential and even risks producing a loss overall.

There are two elements to money management that traders need to consider carefully: how much of your account to risk per trade and how much of your account should ever be at risk whether measured in total or by some kind of sector. There are not necessarily right or wrong answers: what is best for you will depend to a large extent upon your own appetite for risk and tolerance for loss, whether temporary or permanent.

Account Risk

Whenever you open a trade, you are risking money. Even if you have a stop loss, you might suffer negative slippage and lose more than you accounted for. Obviously, if you have a large number of trades open at the same time, even if they all make sense at the individual level, they might together constitute an unacceptable level of risk. Likewise, if you have a lot of trades open that are all betting on the same currency in the same direction, you run a risk of a sudden loss beyond what is acceptable.

For these reasons it is a good idea:

• To determine a maximum size of open trades that you will have at any one time; and
• To repeat the above but per currency.

For example, you might determine that you will never have more than 2% of your account size at risk in open trades or 1.5% at risk on a single currency. You should also be extremely careful when trading in currencies that are pegged or capped against another currency by their respective central banks. For example, anyone who was short the Swiss franc last January using even a relatively very small true leverage of 4:1 would probably have had their account wiped out, regardless of any stop loss, as the slippage was so great.

To a lesser extent, if you are trading currencies or other instruments that have high positive correlations, you might also want to put a limit on total open trades which are strongly positively correlated. This becomes more important if you are trading beyond forex, for example, oil and the Canadian dollar have a high positive correlation.

The exact amount of maximum risk you should use is up to you, but keep in mind that once your account is down by 25%, you need to increase it by 33% just to get back to where you started and the lower you go the worse it gets: a loss of 50% requires an increase of 100% to be made good. Generally speaking, the larger the stop losses you use, the higher your maximum risk can logically go.

Forex Risk Management—What’s Your Risk Per Trade?

Now you have some risk limits set for your account overall and by currency, you should address the separate question as to how much you should risk per trade. Of course, it is OK to risk different amounts per trade, but you should determine this systematically.

There are several variables that should go into position sizing strategies for forex traders, but first of all risk per trade needs to be calculated as a percentage of your total account equity. Total account equity can be determined by looking at the amount of realized cash in your account; you should assume the worst-case scenario i.e. that every open trade will be lost.

There are two advantages of this method as opposed to simply risking the same amount again and again regardless of performance, which is the case when you use a predetermined fixed lot size or fixed cash amount:

NEXT PAGE: How to Prevent Completely Wiping Out Your Account

Forex trading strategies tend to produce winning and losing streaks and not an even distribution of results. Using a percentage of equity to determine the size of each trade means that you risk less when you are losing and more when you are winning, which tends to maximize the winning streaks and minimize the losing streaks.

You can never completely wipe out your account. Using a fixed lot size or cash amount might wipe out your account or at least send it into a decline from which it may never recover.

To illustrate these points, let’s look at the equity curves produced by a real trading strategy applied to the EUR/USD currency pair since 2009:

211 trades were taken, beginning with a starting capital of $10,000 using a fixed profit target of 3 times the risk per trade. The strategy performed very well overall. The red line is the equity produced by risking 1% per trade whereas the blue line shows the equity derived from risking a cash amount equal to 1% of the starting balance. Note how when the strategy is losing, the red line is only slightly below the blue, but during the strong winning streak it begins to outperform exponentially.

Here are some of the essentials you should consider in determining how much you should risk per trade:

• What is the worst performance you might have to suffer and what would it look like? Could you cope psychologically with a drawdown of 10%, 20%, or even worse? Should you ever be that far in negative territory?
• How often you trade will also be a factor, as this will impact your worst drawdown.
• What are your expected winning and losing percentages? Back test your trading. For example, if you have a forex trading strategy where you plan to lose 80% of your trades but win 10 times your risk on the remaining 20%, your risk per trade should be smaller than if you are planning to make 3 times your risk on 40% of your trades. Of course, if you have a flexible exit strategy, then just make an approximation of how it will probably work over time.
• Is it possible with your account size to trade small enough? For example, if you have an account of only $100, and you wish to risk 1% per trade, you will have to risk a single penny per pip with a stop loss of 100 pips. This might be impossible, depending upon your broker. However, you should capitalize upwards or change your trading strategy instead of increasing your risk per trade if that is the case.
• Is your account a nest egg or a relatively small amount of real risk capital? If your total net worth is $25,000 for example, and you have an account of $10,000, you might have less tolerance for drawdown compared to an account of $1,000.

Remember that your money management strategy will interact statistically with your win rate and average win size to directly affect your overall win or loss over time.

Stop Losses and Position Sizing

You should never determine your stop loss as a minimum you can afford. For example, if you want to risk no more than $20 per trade, but the minimum position size your broker will allow is $1 per pip, then that is a very bad reason to use a 20 pip stop loss and a fixed lot size of $1 per pip. You should either find another broker, or increase the size of your account if you have sufficient risk capital, or find a forex trading strategy that commonly uses 20 pips stop losses, if you are comfortable with it.

However, it is very legitimate to determine your stop losses by a measure of averaged volatility, and in trend trading, especially, this in itself can be a very powerful money management strategy. For example, using a multiple of the 20-day average true range to determine the stop, and then basing the position size as a percentage of current account equity, is a very common money management component within forex trend trading strategies.

Even if you base your stop losses on technical levels, it can still be worth using a volatility measure in your position sizing. For example, if the 20-day average true range is double a very long-term average true range, you might risk half of a benchmark risk per pip related to your account equity.

By Adam Lemon, Contributor, DailyForex.com