Money Management for the FX Trader

[Blithe]

Dear All,

I am putting together a few thoughts on money management and I firmly believe that this is an essential part of trading, esp. in the inital stages. After stating a few assumptions, I am analysing it from a capital protection point of view, and essentially laying down a few rules that I use for my trading. Of course they are not complete, and I have simplified them for illustration purposes. Hopefully some people will benefit, and all suggestions are more than welcome.

The primary goal of the exercise is to stress on capital protection. I personally use stops of 3% at the moment and take only one trade at a time. I will not consider pyramiding here.

Assumptions:

(1) At any time, the maximum risk is 3%
(2) Trading only outside of data releases, so no allowances made for slippage
(3) Normal Position sizing R/500 per pip, i.e. the account always holds 500 times the risk per pip. So will need a broker who provides at least 40:1 leverage, if trading cable
(4) My style of trading, I put stops of 15 pips (including commission). i.e., max risk per trade = (100*15)/500, or 3%
(5) Starting capital : £10,000. Margin call at £3,000 if breached. (arbitrary numbers)
(6) Account closed if 70% down.
(7) In case 15 pip stops are not enough, either the risk per pip is reduced to keep the risk at 3%, or the trade is skipped.
(8) The trader has an edge, with at least 60% strike rate and 1:1 Risk Reward. ( I know this is slightly subjective, but this is intended as a fail safe for starting traders)

Since the objective is capital protection, let's consider how many consecutive losses it takes to reach the margin call.

10,000 * (0.97)^y = 3,000.

As each loss results in the account shrinking by 3%, to 0.97 times the amount before the trade was placed.

Sloving for y in one of numerous ways y = (log 0.3)/log (0.97) = 40.

i.e. it takes 40 consecutive losing trades to go bust!

With 2%, the number is 60 trades. This provides you with plenty of ammuntion while looking to implement you edge. However, with the gunslinger's risk of 10%, it reduces to 12 trades. At the manic levels of 20% risk, it takes a mere 6 trades.

The idea of the exercise is to stress on capital protection and why it is imperative to limit your risk to less than 5%. Any system might have a losing streak of several trades, even upto 10, and the more money the trader loses in such situations the more the psychological damage he suffers. By limiting the risk to such small amounts, he has the confidence that makes sure he will survive a losing streak, and bounce right back. Also, the less capability each trade has to scuttle the account, the more you can focus objectively on trading and the less stress and anxiety you face. In case you lose more than 10 trades in a row, I would suggest the edge is not working and it is time for your to stop trading and review your system. 20 trades in a row and just reverse the signals,take profit where you put your stops and you may make a fortune

The other aspect is that in case one loses 50% of the account, he has to make 100% to reach the same level he started. Again, limiting the risk to 3% of the account makes sure he automatically reduces the position size in bad periods.

What's the downside if there is one? Of course you won't be able to double your account in one day. But people who claim to make 100% a day, sooner or later will face a losing streak, and will encounter so much pain that they probably will find themselves unable to trade for several days. Once the learning phase is nearly over, consistency is the next step, and that will lead you to the rewards.

Hope that helps, good luck with your trading!

Blithe

 

[BroadSword]

Thank you for posting this.

The only question in my mind when looking at strategies that tolerate 10 losing trades (say) but not more, on the basis that 11 losing trades is extremely unlikely (or 20 and 21 if you don't like the numbers 10 and 11) but wipes you out is this:

Suppose you never have 10 consecutive losers, but 8 losers followed by 1 or 2 winners, followed by 8 losers, followed by 1 or 2 losers, etc etc...you get the idea!

You don't have to have the 10 losers, do you? You can still easily go bust with a small string of losers, as long as you get smaller stings of winners, or those small strings of losers are frequent enough.

This is what puts me of the idea that (say) 2% risk is fine, as you'd need 50 consecutive winners to lose you account.

It's simply just not true.

 

[Blithe]

Thank you for posting this.

The only question in my mind when looking at strategies that tolerate 10 losing trades (say) but not more, on the basis that 11 losing trades is extremely unlikely (or 20 and 21 if you don't like the numbers 10 and 11) but wipes you out is this:

Suppose you never have 10 consecutive losers, but 8 losers followed by 1 or 2 winners, followed by 8 losers, followed by 1 or 2 losers, etc etc...you get the idea!

You don't have to have the 10 losers, do you? You can still easily go bust with a small string of losers, as long as you get smaller stings of winners, or those small strings of losers are frequent enough.

This is what puts me of the idea that (say) 2% risk is fine, as you'd need 50 consecutive winners to lose you account.

It's simply just not true.

Nice of you to reply on the thread Mate, of course what you say is absolutely right. The only point I was emphasising on the thread was that the goal of this exercise is capital protection only, and I chose the worst possible outcome, reasoning that I can at least place 40 trades with a risk of 3% before a margin call. If I have some winners in the middle, I can place even more trades. I get confidence from the fact that since I have a system that works, it is extremely unlikely that my account will ever blow up, as long as I am disciplined.

I do realise of course that a string of 8 losers with 2 winners followed by 4 losers is pretty much the same as a string of 10 losers. But I kept it this way to make the point across in the simplest possible way. Of course, if you really have a 60% system, chances that you will have 10 losers in a row is (0.4) ^ 10 or .0001! So as long as the edge is valid, you would hopefully never really experiece this much of a string of losses. But that takes us to the coin toss experiment. Chances of a head, 50%. Toss it 1 million times, we are likely to get a 50% head list. can we be sure the first ten will never be tails? Of course not.

The only point I was trying to get across was that with a 2-3% of risk, you get plenty of ammunition to play with, particularly if one is just starting on the markets. And even if you do encounter a list of losers, you will still live to fight another day. And if your edge is good, and you are disciplined, eventually you can teach yourself to trade without blowing up your account. Hope that makes sense.

Best Regards,
Blithe

 

[BroadSword]

Yes, I agree with what you're saying, and the simple maths puts into perspective what many people either chose to ignore or don't want to understand.

Thanks for that!

 

[Spreadbetteur]

You say you are looking for trades with at least 1:1 risk / reward. I have found that it is extremely important that your winners are generally bigger than your losers. If you are day trading this will help to keep you in daily profit, asusming you have an edge.

"i.e. it takes 40 consecutive losing trades to go bust!"

I am a little worried about the exclaimation mark ! Very unlikley to have 40 consecutive losers, even with no system, though if you net winners / losers goes to negative 40, who will you feel, how will that effect your trading ? On countless threads it is reported that "You would need 50 trades to go bust" Always said with a it cannot happen attitude. Though if you are only winning 3 out of ten trades and the size of the winners is more or less the same as the losers, very soon you are at a high negative count.

 

[Blithe]

You say you are looking for trades with at least 1:1 risk / reward. I have found that it is extremely important that your winners are generally bigger than your losers. If you are day trading this will help to keep you in daily profit, asusming you have an edge.

"i.e. it takes 40 consecutive losing trades to go bust!"

I am a little worried about the exclaimation mark ! Very unlikley to have 40 consecutive losers, even with no system, though if you net winners / losers goes to negative 40, who will you feel, how will that effect your trading ? On countless threads it is reported that "You would need 50 trades to go bust" Always said with a it cannot happen attitude. Though if you are only winning 3 out of ten trades and the size of the winners is more or less the same as the losers, very soon you are at a high negative count.

Hi Spreadbetteur,

Rest assured, the implication of that statement was "It is extremely unlikely to have such a string of losses, hence as long as your edge works and R:R >1, you will make money without ever putting your account under threat." I can't stress enough that I considered the absolute worst case scenario to arrive at an acceptable level of risk conducive to capital protection and enhanced confidence while trading.

Sorry if I didn't make it clear enough. But Mate, we also need to be aware that ultimately every trader has to have his/her edge, i.e. a system that gives positive expectancy over a decent sample of trades. If a trader doesn't have an edge, with good money management he can delay the inevitable, but ultimately commissions will eat up his account. Also, any self-aware trader will realise long before 40 net losers that his edge is not working as expected, and therefore his system has to be redesigned.

Cheers,
Blithe

 

[JP1966]

To me it shows that there are many different ways to make (or lose) money.

A lot of people advocate trading outside the times of fundamental annoucements. My trading style means I see these times as the very best opportunities.

 

[Blithe]

To me it shows that there are many different ways to make (or lose) money.

A lot of people advocate trading outside the times of fundamental annoucements. My trading style means I see these times as the very best opportunities.

Hi JP,

Certainly, there are several ways to make money in the market. And as you say trading the news is something which does invites a debate. If OK I will keep my views on trading news to myself for the time being and post it elsewhere more appropriate. While I am sure several traders who know what they are doing, yourself included, use the announcements to try and make a quick buck, I would urge new traders to refrain from doing so.

To address the money management in this case though, the only way I would change the above rules is to include possible slippage within the 3% risk. Since we don't know how much the slippage can be, I would personally use a position size a fraction of what I would otherwise. The worst slippage I have encountered is 75 pips on an entry stop in cable during an NFP last year, and some people have reported over 100 pips slippage. Of course it depends on how imp. the announcement is, and if at all I were to trade over news I would err on the side of caution and use a smaller risk.

To take it to the extreme, I know someone who puts 2% of his equity in a separate account that guranatees the account will never go -ve, and uses it exclusively to trade the news. I don't know which brokers encourage such a practice, but if someone does guarantee stops under all market conditions, that would be a good place!

Best Regards,
Blithe

 

[SvenFoster]

If the intention of MM is to "protect your capital (especially when starting out)" the I would suggest that the smallest position size possible(that would still make you concentrate) is best when finding your edge.

In the early stages MM should be v.conservative IMHO to protect you from yourself but that said... if I'd found any form of MM sooner in my curve I'd be less bitter now

Once happy with your trading you can ramp it up to a level that suits your risk but you shouldn't lose sight of the fact that it is always a balancing act between maximising profits and controlling risk.

Focusing on MM is a sign of trader maturity in my book but then again i'm not profitable so you shouldn't listen to me anyhoo.

 

[G-Man]

You say you are looking for trades with at least 1:1 risk / reward. I have found that it is extremely important that your winners are generally bigger than your losers. If you are day trading this will help to keep you in daily profit, asusming you have an edge.

"i.e. it takes 40 consecutive losing trades to go bust!"

I am a little worried about the exclaimation mark ! Very unlikley to have 40 consecutive losers, even with no system, though if you net winners / losers goes to negative 40, who will you feel, how will that effect your trading ? On countless threads it is reported that "You would need 50 trades to go bust" Always said with a it cannot happen attitude. Though if you are only winning 3 out of ten trades and the size of the winners is more or less the same as the losers, very soon you are at a high negative count.

I agree Spreadbettuer.

Most people only look at the consecutive losers. It is the cummulative net trade balance of profits/losses that is much more important, as this is a much better guage of maximum drawdown.

G-Man

 

[Blithe]

I agree Spreadbettuer.

Most people only look at the consecutive losers. It is the cummulative net trade balance of profits/losses that is much more important, as this is a much better guage of maximum drawdown.

G-Man

Hi Sven,

Agree with you that it is best to trade with such amounts as you are comfortable with, so you can concentrate on your trading and not on money.

Yo G-Man,

The word consecutive seems to have hooked several people and I am sorry I didn't make myself clear. Consecutive losses were taken only to simplify analysis and highlight the worst possible scenario. You can of course specify your own criteria to measure your cumulative performance, perhaps you measure net winners/losers and stop when you have 10 net losers and reassess. Fair enough.

I use a different rule to measure and limit my drawdowns, and this is by specifying a daily, weekly and monthly (thankfully has never come in play, as I trade intraday) stop loss limit. For instance, if my account is down 6% from the start of the day, I stop trading for that day. The reason I prefer this is because I tend to move my stops towards breakeven as soon as I feel it is safe to do so, and in case I see an exit signal I exit straightaway without waiting for my stop to be hit. This rule gives me plenty of room to manoeuvre towards profitability during a day even if I start with a losing trade, yet limits my loss in case I get an occasional bad day.

Regards,
Blithe

 

[TWI]

MM does not only protect capital but allows you to leverage the potential of your system to create far better returns.
I think you need to find a system with positive expectancy and then assess the main variables of the specific system e.g. max dd, win/loss ratio ect. before you decide what form of MM to apply. It can make a HUGE difference depending on what method you adopt and what is suitable for one system will not necessarily be good for another. There is as much fiddling about with the MM as there is with any basic system construction.

 

[Blithe]

MM does not only protect capital but allows you to leverage the potential of your system to create far better returns.
I think you need to find a system with positive expectancy and then assess the main variables of the specific system e.g. max dd, win/loss ratio ect. before you decide what form of MM to apply. It can make a HUGE difference depending on what method you adopt and what is suitable for one system will not necessarily be good for another. There is as much fiddling about with the MM as there is with any basic system construction.

Yo twalker,

Absolutely, I totally agree that all parts of the system should suit the trader's personality and trading method. I suppose by leveraging the potential you mean the opportunity to pyramid? If you some other aspect in mind, care to elaborate?

Cheers,
Blithe