Hi,
I would like to share some ideas, principles and techniques primarily on the topic of position management, risk management, and money management as a whole. Everything is based on my own trading experience and the experience of other traders.
Before I even begin, first lets be clear, this topic is geared more towards the people who are serious about trading and really want to make money. Not the casual fx gamblers, and hobby traders. (But even they can benefit).
I assume that most people here know the basic stuff and techniques about risk management. (Things like - never risk more than 1-2% of your capital per trade, use stops......and so on.) So I will try to focus more on the advanced stuff.
A major problem with many traders is that they focus way too much on finding good entry points and almost ignore the part of active position management. Another common problem is the misunderstanding of the relationship between risk/reward ratios, win rate and probability, and how everything fits in the context of real markets (not just in theory).
To make money in this game you have to learn how to survive in the long run. And to survive in the long run means to plan everything at least a few steps ahead. You have to have plan A, plan B, plan C, and most of all plan for bad luck! Because no matter how good you are, in trading, sooner or later bad luck will hit you, and if you are not prepared it will cost you a lot!
Learn from the mistakes of others!
The experience of other people will give you many important lessons, but some of the most important are:
"Never put all eggs in one basket". So before you even start to trade consider that! Never put all of your capital in one broker or one trading account! Divide your capital on small parts. Keep the large part (at least 60%) in your bank account and only small portion in the trading account - just enough to cover your margin requirements plus a little buffer, and you can use the advantage of leverage to manage you trades based on you whole capital. By doing this you protect your capital against unexpected "black swan" events. Things like broker bankruptcy, or crazy markets events like flash crashes.
You also protect you capital from yourself and the potential catastrophic mistakes that you can make! Because, let's be honest, nobody can blow up your trading account in one trade, only you can do that! And if you make this mistake at least you will not lose your whole capital. Only small portion (what is in the account). There is nothing worse and more demoralizing than losing your entire capital in one trade.
NEVER put yourself in a situation where one position can take you out of the game!
Another good way to protect your capital is to use daily limits. For example if you lose 2 percent of your capital just stop trading and come back the next day. Also learn to stop after profitable day. Don't be too greedy!
Now let's see the main problems people have with money management when it comes to trading. A far as I can see, most traders have poor understanding of the basic probability principles and risk-reward relationships in the context of markets.
Almost all books, articles and gurus are preaching at least 2:1 or 3:1 RR and say that even if you win only 30-40% of the time you can still make money......and in theory this is true. The question however is - how do you get these 3:1 trades? And 95% of people seem to think - easy. You find a trend, enter your position, place a target 3 times bigger than your stop and just relax and wait for the money to come. This assumption is one of the major mistakes most traders make. And can tell you, no matter what your strategy is, if this is how you manage your trades - you will lose in the long run!
You have to understand that this type of passive position management doesn't work in the context of markets. Placing fixed target 3 times bigger than you stop will typically produce very low win rate (less than 25%). The further you place your target - the lower the probability that the market will reach it. Why is that? Because of the fractal nature of markets the probability over time will decrease progressively, but not linearly (like most people assume). Most of the time trends from different time frames are overlapping and cancel each other. The easiest way to see this is just to compare ATR across different time frames. You will find that for example ATR 10 on 4 hour is NOT 4 times bigger than ATR 10 on 1 hour. In fact it is close to 2 times or less.
So with the passive position management even if you are correct on the market direction, chances are that you will get stopped out before the market hits your target.
Some people notice this problem, and decide to play "smart" and scale out as the trade goes in their favor. This usually doesn't work very well in the long run! The reason is, because when you scale out of winning positions you reduce you risk-reward ratio and ultimately your profit potential. When you win the most, you win only on small position, and when you lose the most you have your whole position. To overcome this you need very high win rate, which is not only hard to achieve but almost impossible to sustain long term. When you add the commissions the spread and the slippage, things are getting even worse!
Now let's see the proper ways to manage positions.
No matter what your strategy is, the only way to make money in trading is to have positive expectancy. Your total net profit must be larger than your total net loss (Profit factor bigger than 1).
Somehow you have to make more money on your winning trades(risk<reward) and at the same time maintain good winning rate - at least 40% and preferably over 50%(assuming you have strategy with solid edge).
One way (proper) to do this is to use relatively symmetric stop and target and to scale out (reduce the position) when the market goes against you. Also note that symmetric target doesn't mean fixed target. You will keep the upside open and only limit the downside with hard stop.
The other very important part is that instead of placing the whole position from the start, you split the position. For intraday trading I like to use ratio of 2-1-1 but that depends on your strategy and time horizon. But you have to place larger part at the start and add in smaller parts. This way the average position price will change less.
You only add to winning positions! NEVER add to losing positions! When the position is going against you - scale out (reduce) and when its going in your favor - add (increase).
When you add to profitable positions you have to do it in such way that it doesn't increase the risk. The maximum risk should stay constant. To do this you have to reduce your stop level before you add.
With this dynamic way of position management you put the odds in your favor and even with symmetrical stop and target you will get risk-reward ratio better than 1:1.
Also because your maximum risk is limited with hard (trailing) stop, and the upside potential is open (no fixed target). This way you NEVER lose big, you lose small and win small most of the time, and from time to time you get lucky and win BIG.
If you are doing everything correctly with this active position management, the large part of your profits will come from small number of "lucky" positions, not so much from your strategy or predictive skills. But you have to put yourself in situations where you can get lucky (do not put limits on your upside potential) because in the market there is no boundaries. Sometimes the price goes much further and much faster than you expect! The sooner you understand this - the better.
Basically most of the time you stay at break even, or make a little bit of profit and then out of nowhere - BANG!!! Your win BIG! Initially you expect to make x amount of money..... (Based on the symmetrical approach), but the market doesn't care! The price makes this big fast move in your favor and now your profit is 5 or 10 or even 20 times larger than normal.
This is exactly the opposite of what happens to most amateurs! Most amateurs and even many experienced traders also manage to stay close to break even most of the time, but then out of nowhere - BANG!! And the account is gone! This happens because they don't plan for bad luck! And when you don't plan for bad luck- you actually plan to fail!
They also don't have a plan for good luck! And when good luck comes, amateur traders usually do not benefit much from it because they use fixed targets or scale out of profitable positions too soon (instead of adding to them).
I would like to share some ideas, principles and techniques primarily on the topic of position management, risk management, and money management as a whole. Everything is based on my own trading experience and the experience of other traders.
Before I even begin, first lets be clear, this topic is geared more towards the people who are serious about trading and really want to make money. Not the casual fx gamblers, and hobby traders. (But even they can benefit).
I assume that most people here know the basic stuff and techniques about risk management. (Things like - never risk more than 1-2% of your capital per trade, use stops......and so on.) So I will try to focus more on the advanced stuff.
A major problem with many traders is that they focus way too much on finding good entry points and almost ignore the part of active position management. Another common problem is the misunderstanding of the relationship between risk/reward ratios, win rate and probability, and how everything fits in the context of real markets (not just in theory).
To make money in this game you have to learn how to survive in the long run. And to survive in the long run means to plan everything at least a few steps ahead. You have to have plan A, plan B, plan C, and most of all plan for bad luck! Because no matter how good you are, in trading, sooner or later bad luck will hit you, and if you are not prepared it will cost you a lot!
Learn from the mistakes of others!
The experience of other people will give you many important lessons, but some of the most important are:
"Never put all eggs in one basket". So before you even start to trade consider that! Never put all of your capital in one broker or one trading account! Divide your capital on small parts. Keep the large part (at least 60%) in your bank account and only small portion in the trading account - just enough to cover your margin requirements plus a little buffer, and you can use the advantage of leverage to manage you trades based on you whole capital. By doing this you protect your capital against unexpected "black swan" events. Things like broker bankruptcy, or crazy markets events like flash crashes.
You also protect you capital from yourself and the potential catastrophic mistakes that you can make! Because, let's be honest, nobody can blow up your trading account in one trade, only you can do that! And if you make this mistake at least you will not lose your whole capital. Only small portion (what is in the account). There is nothing worse and more demoralizing than losing your entire capital in one trade.
NEVER put yourself in a situation where one position can take you out of the game!
Another good way to protect your capital is to use daily limits. For example if you lose 2 percent of your capital just stop trading and come back the next day. Also learn to stop after profitable day. Don't be too greedy!
Now let's see the main problems people have with money management when it comes to trading. A far as I can see, most traders have poor understanding of the basic probability principles and risk-reward relationships in the context of markets.
Almost all books, articles and gurus are preaching at least 2:1 or 3:1 RR and say that even if you win only 30-40% of the time you can still make money......and in theory this is true. The question however is - how do you get these 3:1 trades? And 95% of people seem to think - easy. You find a trend, enter your position, place a target 3 times bigger than your stop and just relax and wait for the money to come. This assumption is one of the major mistakes most traders make. And can tell you, no matter what your strategy is, if this is how you manage your trades - you will lose in the long run!
You have to understand that this type of passive position management doesn't work in the context of markets. Placing fixed target 3 times bigger than you stop will typically produce very low win rate (less than 25%). The further you place your target - the lower the probability that the market will reach it. Why is that? Because of the fractal nature of markets the probability over time will decrease progressively, but not linearly (like most people assume). Most of the time trends from different time frames are overlapping and cancel each other. The easiest way to see this is just to compare ATR across different time frames. You will find that for example ATR 10 on 4 hour is NOT 4 times bigger than ATR 10 on 1 hour. In fact it is close to 2 times or less.
So with the passive position management even if you are correct on the market direction, chances are that you will get stopped out before the market hits your target.
Some people notice this problem, and decide to play "smart" and scale out as the trade goes in their favor. This usually doesn't work very well in the long run! The reason is, because when you scale out of winning positions you reduce you risk-reward ratio and ultimately your profit potential. When you win the most, you win only on small position, and when you lose the most you have your whole position. To overcome this you need very high win rate, which is not only hard to achieve but almost impossible to sustain long term. When you add the commissions the spread and the slippage, things are getting even worse!
Now let's see the proper ways to manage positions.
No matter what your strategy is, the only way to make money in trading is to have positive expectancy. Your total net profit must be larger than your total net loss (Profit factor bigger than 1).
Somehow you have to make more money on your winning trades(risk<reward) and at the same time maintain good winning rate - at least 40% and preferably over 50%(assuming you have strategy with solid edge).
One way (proper) to do this is to use relatively symmetric stop and target and to scale out (reduce the position) when the market goes against you. Also note that symmetric target doesn't mean fixed target. You will keep the upside open and only limit the downside with hard stop.
The other very important part is that instead of placing the whole position from the start, you split the position. For intraday trading I like to use ratio of 2-1-1 but that depends on your strategy and time horizon. But you have to place larger part at the start and add in smaller parts. This way the average position price will change less.
You only add to winning positions! NEVER add to losing positions! When the position is going against you - scale out (reduce) and when its going in your favor - add (increase).
When you add to profitable positions you have to do it in such way that it doesn't increase the risk. The maximum risk should stay constant. To do this you have to reduce your stop level before you add.
With this dynamic way of position management you put the odds in your favor and even with symmetrical stop and target you will get risk-reward ratio better than 1:1.
Also because your maximum risk is limited with hard (trailing) stop, and the upside potential is open (no fixed target). This way you NEVER lose big, you lose small and win small most of the time, and from time to time you get lucky and win BIG.
If you are doing everything correctly with this active position management, the large part of your profits will come from small number of "lucky" positions, not so much from your strategy or predictive skills. But you have to put yourself in situations where you can get lucky (do not put limits on your upside potential) because in the market there is no boundaries. Sometimes the price goes much further and much faster than you expect! The sooner you understand this - the better.
Basically most of the time you stay at break even, or make a little bit of profit and then out of nowhere - BANG!!! Your win BIG! Initially you expect to make x amount of money..... (Based on the symmetrical approach), but the market doesn't care! The price makes this big fast move in your favor and now your profit is 5 or 10 or even 20 times larger than normal.
This is exactly the opposite of what happens to most amateurs! Most amateurs and even many experienced traders also manage to stay close to break even most of the time, but then out of nowhere - BANG!! And the account is gone! This happens because they don't plan for bad luck! And when you don't plan for bad luck- you actually plan to fail!
They also don't have a plan for good luck! And when good luck comes, amateur traders usually do not benefit much from it because they use fixed targets or scale out of profitable positions too soon (instead of adding to them).
