FOREX Money Management

Surviving

Successful FOREX traders understand that survival is always their first consideration.

The reason is obvious.  If you blow your account and are out of the market, you certainly will not experience any trading success. The key to surviving is to accept this one fundamental fact of trading:

                                            The outcome of any single trade is completely unknown.

Remembering this fact keeps a trader out of trouble. The message is simple: don’t place to much of your equity on a single trade, because you really don’t know what the market is going to do next.

The famous Turtle Traders used a rule that no more then 2% of an account’s equity could be risked on any trade. While 2% may be too high or too low to suit your risk tolerance, it is important that the decision is conscience and well thought out.

Either way, in order to survive FOREX trading, each trade must be viewed in terms of its loss potential first and its win potential second.

Thriving

Generally, the loss potential of a FOREX trade is the product of the stoploss and the lot size.  Similarly, the win potential is the product of the takeprofit and the lot size. 

Quite often, the stoploss and takeprofit values are determined by the market conditions.  This leaves the FOREX trader with only one value to modify – the lot size.

Assuming there is an interval of lot sizes that do not exceed your risk tolerance, how do find the optimal lot size? Should you use the same value for each trade, or should it vary?

This example illustrates the effect of money, or lot size, management.  (This example is found in Ryan Jones’ excellent book on Money Management “The Trading Game” *).

Consider the following game.

Flip a coin 100 times.

• Each time the coin lands heads up, you win two dollars. 
• Each time the coin lands tails up, you lose one dollar.

As you know, the coin will land heads up about 50% of the time (and tails up the other 50% of the time). If you bet $1 on each flip, after 100 flips, you will win about $50.

The math is as follows:

• 50 flips land heads up -> 50 x $2 = +$100
• 50 flips land tails up     -> 50 x $1 = -($ 50)
• $100 – $50 = $ 50 net winnings.

Clearly, this is a winning game (with a positive expectancy). So, instead of betting one dollar on each flip of the coin, let’s look at the effect of varying the bet size on each flip.

Consider the following scenarios.

• Bet 10% of your total account on each flip.
• Bet 25% of your total account on each flip.
• Bet 40% of your total account on each flip.
• Bet 51% of your total account on each flip.

The mathematics for calculating these results are not trivial to the average trader. (The example and the mathematics are  detailed quite well the Jones* book –  I encourage curious traders to read the book.)

After 100 flips, the results are startling (and non-intuitive).

Starting Capital	Percent Bet	Ending Capital
$ 100	10%	$ 4,700
$ 100	25%	$ 36,100
$ 100	40%	$4, 700
$ 100	51%	$31

My goodness.

To think, you can run a trading system, or an Expert Advisor, that wins twice as much as it loses and actually lose money.

Or you could be up over $36,000!

Clearly, FOREX traders need to take a good hard look at lot size management. 

  

* Ryan Jones. The Trading Game: Playing by the Numbers to make Millions. New York:  John Wiley & Sons, 1999.

Jones’ example is actually from Portfolio Management Formulas, by Ralph Vince (New York: John Wiley &Sons, 1990).