Basic Money Management in Trading

 

Hello there, this is tradingpedia.com and this video deals with basic money management rules in trading. It does not refer only to the currency market, but to be applied on anything that you might trade – currencies, gold, CFDs, etc.

Risk-Reward Ratio

Any trade requires a proper risk-reward ratio, also called rr ratio. A proper ratio is 1:2, namely if your risk is $2, you must make minimum $2 on that trade for it to make sense. To put it in a different perspective, every successful trade gives you two chances to fail and still not lose money. The higher the rr ratio the better. In order to use a proper rr ratio, any trade must have a stop loss and take profit order.

Many traders ignore the stop loss, preferring a mental stop instead. This is wrong because human nature leads to traders avoiding the stop. Why would you do that? If the market reverses to the stop it means that the trade idea was wrong. So let the stop loss order do what it is supposed to do – to stop the loss.

How to build up a risk-reward ratio? The EURUSD here formed a triangle that broke higher in March with the pandemic. This was a triangular, called a non-limiting triangle in terms of Elliott Waves.

It is usual that after the breakout the market comes and retests the trendline. This would be a nice place to go on the long side. If we go long here on the EURUSD, we need a stop loss. What would be the level to invalidate the position?

Determining Where to Set Your Stop-Loss

The stop loss would be the lowest point in the last leg of the triangle. If we use a trendline and mark the level and this would be the entry place, then this is the risk for the trade. We need than the reward equaling more than twice the risk and project it twice to the upside and that would be our target.

For the trade to make sense, going long here requires remaining on the long trade all the way to here. However, there is a catch. This is the daily chart and such a distance is quite big. For instance, the entry is 1.09 and stop 1.0772, so 120 something pip points. Depending on the volume traded, each pips may have a different value. For example, 0.1 lots on the EURUSD equals $1. But if your trading account is only $100, that means 10% of the trading account, which is not good.

Set Yourself a Maximum Loss Threshold

Another money management rule says never to risk more than 1% or maximum 2% of the trading account on a trade. There is a difference between the balance and the equity of the trading account. The balance represents the money that you fund the trading account with and it only changes with the closed trades, but it does not show the actual equity – and that is the 1% or the 2% rule it refers to. So how to convert this one? Very easy!

Let us say that you have a trading account worth $5,000. In order to risk 1% of it, if the price reaches the stop, the loss is $50. If it reaches the take profit instead, the profit is $100. The key is to convert the volume traded per position in such a way that the account does not suffer a loss bigger than $50. So if 0.1 lots mean $1/pip and you need 100 pips for the stop loss, then the proper volume would be 0.05 or half of the 0.1 volume.

This is how to convert the percentage or the risk of a trade into the actual volume to trade and that is the strategy explained. Why is important to risk only 1% of the account on any given trade? If you end up having more than 72 consecutive losing trades, it only means a 50% drawdown in the trading account. If this happens 72 times in a raw, maybe trading is not the thing to look after. So this is very important because it protects capital, because it gives you the chance to fail without affecting the trading account too much.

Conclusion

These simple money management principles can be used on all trades and setup. As long as you know your stops and entries, you can convert the position to find out the size of the trade and control how much it will affect the trading account if things go wrong. Thank you for being here and bye bye.