Money Management

Money management is an incredibly important topic. I would argue that it is more important than entry methods or trading psychology. Money management is what protects traders from blowing up their account when they have got the direction of the market completely wrong and allows a trader to benefit from compounding returns over time if they are consistent in getting the direction consistently right.
Money management is an incredibly important topic. I would argue that it is more important than entry methods or trading psychology. Money management is what protects traders from blowing up their account when they have got the direction of the market completely wrong and allows a trader to benefit from compounding returns over time if they are consistent in getting the direction consistently right.

“Survive first, and make money afterwards.” – George Soros

There are four money management objectives of a good trader:

The first objective is to preserve their trading capital so they can live to trade another day. If you wipe your account out through misadventure, that is it, no more trading … back to Burger King to flip burgers until you build your trading stake up again;
The second objective is to grow your account through the miracle of compounding. If you read any book on making money for dummies, this is one of the first principles they will teach you. For example, if you aim at simply trying to increase your account consistently by 6% a month, you will double your account within 12 months. Now in reality, your account will change much more erratically than that as you will have good months and bad months, but you get the principle;
The third objective is to diversify your portfolio of positions, to further protect yourself against isolated extreme moves in a single market. Hedge fund managers invest significant amounts of effort in this space to build a suitably non-correlated portfolio to protect themselves. You should too; and
The fourth objective is to take a leaf out of the books of professional gamblers and use an anti-martingale strategy. Good gamblers know to bet big when the odds are really in their favour and reduce their risk when things are not going so well. For example, a professional black jack player will continually count cards and when the odds are in their favour they will increase their bet sizes. A good trader needs to do the same.
The Line in the Sand
The line in the sand is a line you should not cross in terms of a loss in your account as it means you are doing something really wrong. If you have a realised or unrealised loss of more than a third of your trading account (from the peak in your equity curve), then it is time to close out all your trades. It is time to take a reasonable amount of time off to get through the grieving process, understand in depth what you are doing wrong and go back to the drawing board, because your current trading plan sucks.

Some traders set their line in the sand at 50%. Where your line in the sand is set is up to you. Personally, I think 50% is way too high.

Position Sizing
I prefer to use a fixed fractional approach to position sizing. I am not a big fan of other forms of position sizing (such as fixed lot sizes). Fixed fractional trading lets you have the benefit of reducing your risk of ruin and also permits compounding of your account.

I calculate the position size based on the distance of the stop from the entry point:

position size = (percent risked * account size) / (number of pips between entry and exit point * pip value)

When you use fixed fractional position sizing, it is important you always use the stops distance as part of the calculation. I have seen so many beginners just blindly calculate 2% of their account as their position size.

Making this calculation is non-trivial as pips sizes vary depending on whether the market you are trading is “based” in US dollars. Similiarly, having an account that is not based in US dollars can also get confusing. I tore my hair out on a spread sheet to help me do this right. Fortunately, there is a really neat online tool that simplifies the whole process. Go and check out forexcalc.

The other comment I hear is “fixed fractional position sizing cannot be used in forex markets because the lot sizes are too big – it is only applicable to stocks”. This is absolute garbage. Rather than using a broker that forces you to use huge round lots, consider using a broker that will allow you to use arbitrary position sizes or microlots, such as Oanda. Taking this approach also means that you won’t be over exposing yourself to unnecessary risk by rounding up position sizes or under-leveraging your position and costing you profits by rounding down.

Finally, you will also notice that you can gain a serious amount of extra leverage on your position size by using tighter stops. However, be careful doing this, because if the stop is too close, market noise will stop you out unnecessarily. Finding the right place for a stop takes skill because you need to balance market noise issues against leverage gained from tight stops. One way around this of course is to look for entry points based on break outs from tight congestion areas as they will allow you too have tighter stops.

Portfolio Size
This defines how much risk in open positions you are willing to accept. I use an anti-martingale strategy for determining the maximum number of open positions. When the odds are against me, I will reduce my risk exposure and when the odds are in my favour I will increase my risk exposure. This can be done by looking at the correlation between markets. When all the markets are trending together in concert I widen my risk exposure because there is an underlying theme driving all the markets. When the markets are not moving together, I cut back my risk exposure as there is no underlying theme here driving the market. Depending on market conditions, the total maximum risk exposure of the portfolio will range between 0% and 10%, but will average around 5%.

When all markets are moving together and breaking major new highs, beware of corrections. It may be worth cutting back your total exposure to ensure you don’t get caught out if a major regime shift happens.

The other thing to be wary of is your exposure to a currency. For example, if you had several positions consisting of a EUR/USD long, USD/JPY short, GBP/USD long and a USD/ZAR short, you are over exposing yourself to the USD. Keep an eye on your portfolio makeup.

Percent Risked: 1% or 2%?
Some traders use 2% fixed fractional position sizes when they trade. They probably got this from Alexander Elder’s books, which is written for traders with smaller accounts. Other traders use a 1% position size, probably based on the advice from the original turtle trading system, which was designed by institutional traders with much larger accounts.

If I were to use a 2% position size, it would take a string of 11 loosing trades in a row before I hit my line in the sand. This is more than likely to happen if you get the direction of the market completely wrong. On the other hand, using 1% positions means you will need to get to do more than 22 dud trades in a row before you hit your line in the sand. From a loosing streak perspective, 1% has its advantages.

On the other hand, with an average portfolio commitment of 5%, with a 2% position size you will be holding open 2-3 positions and with a 1% position size you will be holding open an average of 5 positions. Given that there are only a handful of markets in the FX market, finding 5 high quality trades to open is going to be much harder than 3. Therefore, from a trade quality perspective, a 2% position size has its advantages. There are obviously no perfect answers here, so I split the difference and use a 1.5% position size.

Note that 1.5% is hardly mathematically optimal. You could get really clever here and use optimal-F or the Kelly formula to determine the optimal position size. However, the problem with such methods is that they assume that a trading system has consistent performance across all market conditions, which is patently not the case. Also such methods tend to drive you to opening large position sizes (10-12% is not uncommon), so it puts you at high risk of a string of losses hitting your line in the sand. So I tend to stay away from this approach and use a more conservative level.