A money management strategy is probably the most important part of your Forex trading. It’s up there in importance with the actual trading strategy that you are using. Put bluntly, if you don’t get your money management strategy right you’ll lose your bank quicker than you ever anticipated. Forex trading can be fast and furious and if you are losing even as little as 2% of your bank on a lot of your trades, you could see your bank literally wiped out. No system in the world is 100% perfect, which means that you will suffer from losing trades as well as having the thrill and enjoyment of winning trades.
To find out how good your system is you need to paper trade it for a reasonable length of time. You should trade any new system on paper for at least a month, ideally longer than that. You also need to keep a close track of your full results and not just the winners. Once you’ve done this for a reasonable number of trades you’ll have a fair idea of your strike rate. Mathematically this test won’t be perfect but the more trades you have, the closer you will get to an accurate idea of the likely result of any given trade.
Let’s take an example where 1 in 4 of your trades are profitable, which is actually enough to turn a decent trading profit so long as you’re in control of your bank.
With on average 25% of your trades profitable, you can expect approximately 25 out of every 100 trades to show you a profit. It won’t be exactly that figure. You may get as few as 20 winners or as many as 30 on any given batch of 100 trades but, over time, that’s the number you’d expect.
The trouble is that the winners and losers won’t come at regular intervals. The actual pattern of winning and losing trades follows the binomial distribution which shows the probability distribution of the number of successful trades.
Your money management strategy needs to be designed to take into account potential losing streaks.
For instance, if you used 10% of your bank on each trade and suffered just 5 losing trades, you’d only have 59% of your bank left (your bank goes down with each unsuccessful trade) whereas if you used only 2% of your bank on each trade and suffered the same 5 losing trades, you’d still have over 90% of your bank left. If you were ultra cautious – as you should be when you’re starting out with a new system – and only used 1/2% of your bank on each trade then you’d still have over 97% of your bank left.
OK, you’re doubtless thinking that lower losses mean lower gains. Which is true but would you rather still have money in the bank to trade with because you’ve traded cautiously or would you prefer to follow in Nick Leeson’s or Jerome Kerviel’s footsteps?
You should also remember that even small gains can mount up significantly. For instance, my system aims for an average target of 1.5% per day using trade sizes of between 0.5% and 1% of your bank. Since gains are compounded, this would mean that your bank would grow by approximately 7.7% per week.
Over the course of a year, this could turn a £20,000 bank to one that was almost £1,000,000. With that kind of potential gain, it’s not worth risking more than 0.5% to 1% of your bank.
Money management is probably the most important part of your Forex trading. If you don’t get it right then you run a high risk of losing your entire bank or suffer a massive drawdown.
Although it probably initially seems the most boring part of your trading, over time you will come to recognise that it’s actually at the heart of every single system. Conserving your bank so that you can trade the next deal is an essential part of your money management strategy.