Money Management Rules

WARNING FOR TRADERS !

The FX Marketplace is a very vicious battleground. The banks, hedge funds, brokers, the platforms, other traders, all have one aim only – to separate you from your money. I am an individual private trader. I have learnt the hard way and experienced all the tricks that the large traders, banks, brokers and platforms are capable of. Today even Central Banks actively participate in the forex market. This is a sea full of sharks and we are tiny fish among them. I am still learning new things after 20 years, and have to remain constantly vigilant.

I want you to be profitable. This is possible, if you are a disciplined trader. I have a system that has proved itself consistently profitable. It is based on technical analysis – chart patterns, price action, sentiment and market timing cycles. If you follow my trades in real-time you will be profitable. A big part of my system is correct order sizing, or risk management.

Risk Management Rules (also known as Money Management Rules)

There are many methods that work in the markets. What is it then, that separates consistent winners from losers?

One factor: Good risk management discipline.

There are many variations of good risk management rules that are effective. What makes a trader successful over a long period is DISCIPLINE. Discipline means sticking to the rules of the system he/she has adopted for trading.

Through my research I have come to the conclusion that for a small retail trader its best to trade only the major forex pairs: EURUSD, USDJPY, GBPUSD, EURJPY, and AUDUSD, and secondarily GBPJPY, AUDJPY, USDCAD, EURGBP, EURCHF. In the last 7 years all moves in the FX market have become more correlated – the Risk On / Risk Off or Strong dollar / Weak dollar mantra. I’ve found that trading only major pairs is sufficient. Any moves in exotic pairs will be derived from moves in the constituent main pairs, so why suffer the poor liquidity and poor spreads on crosses?

OVERVIEW

Below is my method for managing risk – you may vary this to suit your situation, but whatever method you choose, you need to be disciplined about sticking to your rules.

My example account’s starting value is $100,000. I split that total account into sub-accounts for each pair, as you can see in my monthly reports. The major pairs sizes are set at $15,000, with GBPJPY given $10,000. In each pair, I risk a max 5% of that sub-account on each trade, which means I effectively risk only 0.75% of my total account on each trade. I set the stop-loss for each trade based on the technical setup for that pair. The stop-loss then determines the trade-size. So if the stop is wide, the trade size is small, and vice-versa. In times of heightened volatility I suggest a lower risk, in which case I set the risk at 3% of the sub-account size of that pair.

The benefit of this approach is that if I have a string of losses in a pair, it’s sub-account gets smaller, which automatically reduces the trade size for subsequent trades. On the flip side, if there is a string of winning trades, the trade size automatically increases with each subsequent trade. This effectively implements the old trader’s advice of ‘Cut your losses and add to your winners’.

There are other considerations in trade sizing and risk management which I will not go into here as it would make this post too long.

If you’re following my system, follow these rules strictly. Do not second guess or change them in any situation, except to reduce risk.

First: Select a diverse, high-liquidity set of pairs to trade.

Second: Allocate the weight you wish to give each pair in your trading, and apply the rules below to each pair individually.

For example, if your account size is $50,000 and you prefer to trade only  EURUSD, USDJPY and AUDUSD, I suggest allocating (1/3 * 50,000) = $17k+$17k+$16k to each pair.

Rule # 1. Risk only 5% of each sub-account on each trade. Aggressive traders may risk up to 10%, but I recommend 5%.

How to calculate the amount risked on each trade: Let’s say your Sub-Account value is $20,000. Let’s assume you have a policy of risking a maximum of 5% of the account on each trade. i.e. The amount available to you for each trade is ($20,000 x 5%) = $1000.

Let’s take an example of a EURUSD trade with a stop loss of 50 pips. The pip value for the EURUSD trade standard lot is US$10. This means the risk on one lot is $10 x 50 pips = $500. Limiting your risk to 5% ($1,000) means you can afford a maximum of 2 lots only for this trade.

pip values of trade pairs: All xxxUSD pairs have a pip value of US$10. All xxxJPY pairs have a pip value of Yen1,000. At an exchange rate of $1 = 80 that works out to US$12/pip; at an exchange rate of $1=120 the pip value works out to US$8.3. You may  round this down, but not up!

Risk is the first thing you should look at in a trade. i.e. first set the stop loss, and then work out what order size is compatible with that stop loss. Many traders place the order first and then figure out somewhere convenient to place the stop loss, which is the wrong way around. The stop loss is determined by technical factors, not the trader’s whims. In my system, I set the stop loss for the trade. The follower then should use the order size appropriate for their account value.

Rule # 2: Do not risk more than 8% of your account in total on all trades combined. For example, with the same 50 pips stop loss and 5% risked on each trade you can have at most 5 such trades open simultaneously. Aggressive traders may increase this to about 10% maximum. 

Rule # 3: When pairs are highly correlated (a) trade only the more liquid pair and (b)  do not risk more than 5% of your total account on the combined trades.

The danger with risking higher amounts on each trade is that when the trade goes against you, you will be staring at a pretty large potential loss. The situation is multiplied if the pairs are highly correlated. 

Summary: Work out your order size and do not trade more than the limits I’ve given above.

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One thought on “Money Management Rules

  1. Pingback: First week 2013 trades review « Zen and the Art of FX Trading

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