What Is "Proper" Risk/Money/Trade Management?

Some time ago, another member had made a comment that I did not discuss Money Management in one of my other threads. That is a HUGE topic. There are several successful money management approaches from the Newbie level to the Professional Level.

As with anything else, the success of a money management approach can only show its true worth as a result of the way it is followed by a trader.

In this thread, I hope we'll discuss some credible methods used by traders of all levels. This is not a thread for ridiculous, futile arguments just for the sake of arguing. Some traders do well with no stops; some insist on them. Are both making money monthly or annually? If they are, great.

Each trader must find what works for them in their money management approach. Let's explore the possibilities and maybe traders can get on with the business of making and keeping money consistently, and find something that works for them...and the level of risk you decide to take must be something that you're comfortable with.

FX4...

To start this off, without getting into a specific method just yet, I think most if not all traders would agree that the best approach is to make the most amount of money with the least amount of risk.

Traders generally use Technical Analysis to help them find low risk entries and probable profit targets. If you don't have a credible trading method, that has been put to the test for reliability, then you may be skipping a step by coming here. Nevertheless, something might be said to help you so press on.

First I think I want to discuss the idea of risk...that would be coming next.

FX4

Got this from Wiki...emphasis mine.

Risk is the potential that a chosen action or activity (including the choice of inaction) will lead to a loss (an undesirable outcome). The notion implies that a choice having an influence on the outcome exists (or existed). Potential losses themselves may also be called "risks". Almost any human endeavor carries some risk, but some are much more risky than others.

For those who have traded for any length of time, it should be clear that every price area on a chart does not offer the same degree of risk. For example, selling into a tested support level, all other things being equal, is very likely trading suicide, especially trading with a highly leveraged account and a large position and a big ego. What is in the formula there?

1.Bad trading method, or just an upside down trading day.

2. A desperate, one-time money management strategy (not desirable)

3. A trading psychology profile doomed to failure.

Next I'll be looking at a chart and discussing some risky spots on the trading battlefield.

FX4

Now, any trader looking for a decent short in that gold rectangle because they saw a red candle is asking for trouble, regardless of their "ideal" Risk/MM strategy.

Your risk management starts with how you approach price action (PA) and the chart. No getting around it, otherwise, you'll be stopped out to a "zero level" of trading capital, one trade at a time...mho.

FX4

So, assuming you have a good trading approach in place, how should you "allocate" your trading resources? How much risk should you take? Now those are million dollar questions.

It is said that professional traders would generally not risk more than 1-3% of their trading capital on any one trade. Here's how that would play out...

Let's say your trading account balance was $2,000.00. 1% of that would be $20.00. So, a trader using that % should not allow a loss of more than $20.00 on a trade with that account balance.

What size position should they take? What percentage of the equity should be used to open a position? That discussion will begin next.

Btw, not validating any numbers here...just discussing.

FX4

I like this post from Hanover as it would help in our discussions going forward. Here's the part I especially liked:

With trade management, unless your decisions have statistical or technical basis, they are effectively nothing more than a 'feel good' measure. It's arguably better to set your exit points at the time of entry, when there is less emotional pressure. Then, unless the trading landscape — from the standpoint of your proven rules — has changed since the time of your entry, there's no logical justification for micromanaging the trade.

FX4

Given the fact that there are many dynamics involved here, let's just start with a simple scenario.

A trader opens an account with $1,000.00 US. What kind of risk/money/trade management should they use? Starting with the more common scenario of using stops. Once again, not advocating anything here.

If they are willing to risk 1% of their capital on a trade, then they are only "allowed" to lose $10.00 per trade. That's 10 pips; a tight stop for FX if they're trying to trade 1 mini-lot. If they're trading 1 micro-lot, then that allows for 100 pips. Not saying they have to allow such a large stop or have to budget their risk amount to lose the $10.00. But, most new traders don't want to have to employ the degree of patience and discipline to tolerate trading mini-lots. Hmm...but it might be a better MM consideration.

So, how much of their capital should they use to open a position? 5%? 10%.

More to come...

FX4

Thought I should mention this here....a cash stop of 10 pips (as in our example) in the middle of the line of fire is not a good idea. Stops shouldn't just go anywhere and in some cases, there is a better time to place the stop than others. What do I call the "line of fire"? 10 pips from the current price after the market has started going in your trade direction, without consideration for support or resistance areas.

FX4

Thank you for starting this thread, I think this should be listed in trading as the first thing that needs to be learned. This is a game a capital preservation.

Hopefully you will also later go on to discuss the fixed fractional (like the 1%-3% method) and maybe fixed ratio (where you risk a fixed amount) methods, and pro's and cons of each.

Hi Krypty,

Thanks for posting. So much to cover, just trying to get a little footing from which to branch off. We'll cover those and other approaches. Maybe other traders can drop a suggestion in too as to a method we can discuss.

Take care,

FX4

Now let me ask, how many traders enter a trade with the size of the position they intend to trade with then add a stop for protection and then wait to see what the market does with it? That could be the way the majority of traders do it...and that's fine if you trade your method in a very disciplined fashion, and you're profitable and satisfied with that.

What about this...

Why not enter the market with a micro-lot to see if your trade direction has merit BEFORE committing to a larger position? You'll get the same message from a stopped out trade on a mini or a standard lot as you would from a losing micro-lot trade (with or without a stop). Why pay more for the same information.

Any thoughts?

FX4

A question to FX4Newbies:

How to determine which position size is correct?

Let's assume an account balance of 1000,00 USD and let's assume a maximum risk of 2 % = 20,00 USD. To make things easier, the trader sets a maximum effective leverage of 10:1, so he will never open a position greater than 10,000 or 1 mini lot even if it less than 20 USD in risk.

The trader usually risks between 20 - 50 pips. Assuming he risks 30 pips on one trade, he could trade up to 6 micro lots. But like you said, why should the trader always risk the maximum amount of his limit? It's sound like he WANTS to lose the 20 bucks.

So how to determine the position size?

2 micros? 3 micros? 4 or 5?

How may a trader objectively choose his position size with a reason behind it and not just because a feeling he should risk more on the trade on the base of a good feeling?

So, how much of their capital should they use to open a position? 5%? 10%.


FX4[/quote]

I don't think that is a far measure since max leverage allowed varies from country to country.

OMGTrader,

You bring up a valid point. To my knowledge, the US has made the maximum leverage 1:50. That has created a need then for greater capitalization in order to trade the position sizes a trader might have been used to. Adequate capitalization is another MM issue; but let's move on.

So, let's add leverage to the mix...

At 1:500 leverage, 1 Std. Lot would cost about $200.00 USD, depending on the margin requirements of the broker. So if the leverage were 1:50, 1 Std. Lot would cost about $2,000.00; 1 mini-lot $200.00 and 1 micro-lot $20.00. 5% of their capital of $1,000.00 would be $50.00. Back to the concern, would a trader be patient and disciplined enough to work with mircro-lots? Would they be willing to work within more conservative limits? Is 5% high enough? Would they only increase their position size when the market showed a very high probability trade with a good potential return?

And we still haven't discussed various styles of trading where some traders may even use up to 50% if the market were really going their way and trending nicely.

Thanks for raising that good point.

FX4

...and yes, I do like yogurt

Hi Forex5050,

[A little confusing here...

Let's assume an account balance of 1000,00 USD and let's assume a maximum risk of 2 %= 20,00 USD. To make things easier, the trader sets a maximum effective leverage of 10:1, so he will never open a position greater than 10,000 or 1 mini lot even if it less than 20 USD in risk. Then, in the next paragraph...The trader usually risks between 20 - 50 pips.

I'm comparing the use of the word risk in those instances.] Maybe this is something traders don't think about, but you are really not "risking" your margin. The trading capital left in your account after you place the trade is at risk. If a trader puts on a trade in retail FX, and they lose all of their capital, when the broker closes the trade, their margin (or most of it depending on when the trade was actually closed) goes back to the account.

Now to the other part of your question:

The trader usually risks between 20 - 50 pips. Assuming he risks 30 pips on one trade, he could trade up to 6 micro lots. But like you said, why should the trader always risk the maximum amount of his limit? It's sound like he WANTS to lose the 20 bucks.

So how to determine the position size?

2 micros? 3 micros? 4 or 5?

If the trader sets the leverage at 1:10, the a micro-lot would cost roughly $100.00. So, if the account balance is $1,000.00, then trading 1 micro-lot he would be using 10% of his capital. Not sure how you got it so that he can trade up to 6 micro lots.

Risking 30 pips would be about 3% of his $1,000.00 capital. That amount is what he would be willing to lose if the trade went against him , not how much of his capital he would be willing to use to open the position.

Given your scenario at 1:10 leverage, 2 micros would utilize 20% of the capital in the account. What should be the position size? 1 micro is conservative. Brokers like Oanda would allow even smaller sizes. If the trader decides to go up to 3 micros, that would cost 30% of his capital. On those 3 micros, the trade would have to be down a total of 300 pips (or 100 raw pips) to be down $30.00:

With 1 micro(lot), a 10-pip move = $1.00 roughly. So a risk of $30.00 (3% of $1,000.00) would allow for 100 pips against the trade on 3 micros...roughly. The exact amounts would depend on the pair traded.

If a trader can open a trade with the smallest size possible, then scale in as their trade produced some profit, that would be ideal. If 3% is the amount a trader is willing to lose, then they can work backwards and calculate their maximum or appropriate position size given their choice of leverage. Of course, they should also consider market conditions and how they are feeling at the moment they are trading.

On another note, what position size is "correct" is the one you feel most comfortable trading: the one that does not deplete your emotional equity to vulnerable levels within reasonable/sensible percentage limits.

Hope that helps,

FX4

EDIT: The clarity for the portion in the red brackets came later.

Sorry but that's wrong. A "micro" account trades at (roughly, and as low as) 1 cent per pip. A mini account trades @ (roughly, and as low as) 10 cents per pip.
A mini account is basically the same as a standard account that allows you to trade $10,000
A mini allows you to trade (as little as) $1,000 and it changes from .10 (10 cents per pip) to .01 (1 cent per pip).

This thread seems like a very long-winded way to work out risk and trade size!

$10,000 equity
1% risk - $100
Stop Loss - 50 pips
$100 divided by 50 pips - $2 per pip
Trade size - ~20,000 units give or take

Margin requirement and leverage are irrelevant calculations in this context.

Hello Slim Buffett,

I was not referring to what is the range allowed in some accounts whether micro or mini. I was discussing what happens with specific position sizes. When trading 1 Std. Lot, each pip represents a $10 move in your account balance (roughly). Working backwards...1 Mini-lot would be $1.00 per pip, therefore 1 micro-lot would be 1/10 of $1.00 which would be 10 cents per pip (not the fractional pip on these extended quotes e.g. EU 1.2345[5]. The fractional pip [5] is .01 cent per [1] move. It works somewhat like the odometer in the car that counts the miles travelled. I don't know what they call position sizes smaller than a micro-lot (nano-lots?). One micro-lot represents 1000 units of the base currency. One Std. Lot allows the trader to control 100,000 units of the base currency. This has been my experience on most retail FX platforms.

I once traded on a Demo platform where it was incorrectly calibrated and I had to let the broker know about it.

Thanks for the post.

FX4

I like your quick calculation method Pipmutt. Margin and leverage may not be important here (in that particular calculation), but in other contexts they might be necessary considerations.

This thread is about exploring many ways traders manage their equity and trades. There is certainly more than one.

FX4

A waste of time?


Right, so why are they included in the discussion and examples, it could be confusing.


There are an infinite number of ways, are you planning on covering them all 'cos we could be here a while!