If you haven’t started thinking about money management in your trading, and instead are assuming ‘your entry system’ will carry you to success then think again.
Money management is the cornerstone of trading, without it, your trading results are going to flounder.
This article will introduce the ideas of % risk and R-multiples, two concepts that help lay the groundwork on money management basics.
Getting rich quick or die trying
It saddens me that Forex is often seen as a way to get rich quick.
Propaganda is pumped out by marketers who choose to earn affiliate commissions rather than having the courage to trade themselves.
Still, these dream merchants are good at what they do; tricking hoards of new traders into thinking FX is a way to get rich quickly and will little effort.
Many beginners haven’t even grasped money management basics before they start plunging away in Forex and CFDs.
Don’t be like one of them, learn to develop the three essential trading skills; market timing, emotional control, and money management.
Letting profits run, cutting winners short
This is the essence of great risk control. It is the mantra cited by all traders because it’s the absolute truth.
Your goal is to make the sum of your wins more profitable than the sum of your losers, nothing more, nothing less.
A high win/loss ratio is admirable but comes secondary to sound money management.
Even systems with high win/loss ratios can be net losers, without risk control
Conversely, low win/loss ratios can be net profitable if they are followed.
Some of the best traders ever (usually trend traders) have had 30% win rates and still made fortunes.
What is a good win/loss ratio?
While some of the world’s best traders can win less than half the time and not let it affect their psychology, new traders need positive reinforcement on a regular basis.
This is understandable and how it should be. By hitting the cash register often you get positive feedback as you are progressing.
But many newcomers are unrealistic about their win ratios. They want systems that produce 80-90% winners!
This need to win so badly is rooted in fear of losing money rather than some innate trading skill they possess.
70% is a great win rate for professional traders.
And 65% is an achievable target for a beginner.
With tight money management, a 65% win rate can be hugely profitable.
Think in probabilities
Neophytes also need to adopt the mindset of professional traders. But what does this mean?
It means, thinking that each trade is a separate outcome, independent of any future outcome.
It also means a ready acceptance that in trading, anything can happen at any time.
While this is the emotional control part of trading, if you can’t execute a system with Dr Spock like discipline, you’re not going to get the best from any money management system you use.
Thinking in probabilities means accepting both hot and cold streaks will happen, and not letting it destabilise you through greed or fear.
Successful traders split their trading funds into slices as they never know when losing streaks will happen.
Dividing capital into many portions gives you a level of protection if any trade goes wrong.
In Forex, the much-touted % risk allocation is 2% per trade.
There is nothing wrong with this, but it’s a generic answer.
Day traders might choose to divi up their funds into 1% portions, scalpers 0.5%.
Traders using weekly charts might opt for 5%.
The division of capital, or % risk, is a very important component of money management systems.
If you don’t do this, and instead risk too much for too long, then a cold streak in your system’s performance will take you out of the game at some point.
R Multiple losses
R means risk.
It is the dollar amount at risk (GBP, AUD etc) on any one trade.
Let’s say you have capital of $1000.
You decide to risk 2% on each trade.
In this case, 1R equals $20 (2/100*1000)
R-multiples are useful. They make it easy to see the true performance of a trade or system.
When allocating risk percentage it’s possible to lose the full amount of that risked.
Losing one full risk allocation is called -1R.
We should rarely lose more than 1R if we use protective stops, the only occasion this might happen is when markets gap strongly.
One of the reasons why trading Forex is attractive compared to traditional gambling is; you don’t always lose your entire stake as you would in many betting games.
With the use of a trailing stop, you might only lose half your risk, 0.5R
Or a quarter your risk, 0.25R
Keeping these losses small helps towards the goal of profitable trading.
R Multiple profits
The success of a trade is not measured nominally.
Making $100 on a trade tells us little.
We need to know how much was risked to make that $100 gain.
If we risked $50 and made $100 that is a 2R profit.
If we risked $10 that is a 10R profit.
High R-multiples are what we should be aiming for, and the only way to achieve this consistently is to let profits run.
When fear gets in the way
Trading, in an ideal world, should be purely a numbers game by consistently executing our strategy.
But it isn’t an ideal world, inexperienced traders often get in the way of their own success.
Each trade is supposed to be independent of any other trade.
But this isn’t always the case.
You might have heard the phrase, a general always fights his last war?
Well, there is such a thing as a trader who always trades his last trade.
In this situation, every trade is executed through the prism of the previous one.
For example, if you thought your stop was too tight last time round, next time you use a wide one.
Or if your last breakout trade failed, next time you choose to short at resistance (just as it breaks out)!
This is a cycle new traders keep repeating and is a leading cause of failure.
It skews the cold hard maths of a money management system.
Trading is a numbers game only if we execute with perfect discipline.
Constantly tweaking, changing or overriding a system reduces the effectiveness of what could be a profitable strategy.
Just a quick recap on money management basics.
Some see Forex and CFD trading as a route to get rich quick, but those who do, rarely trade for long.
To accept inevitable losses, traders need to think in probabilities because no trading outcome is ever certain.
Developing this mindset helps remove attachment to both hot and cold streaks.
Successful traders divide their capital into small percentages of the total funds, this is called % risk.
For some 2% is comfortable, for others, like scalpers 0.5% is appropriate.
By following this method no streak of losing trades can ruin your trading account.
Trade performance is measured in R multiples.
1R is the money equal to your % risk allocation.
If you are losing more than 1R you are either not taking our losses as you should, or you have experienced gapping markets.
You should always aim for high R multiples such as 3R, 5R and 10R.
This is done by letting profits run, the most important tenet of money management basics.