Solid money management rules and a sound understanding of correct position size, underpin the trading plans of all successful forex traders, and yet this is an area of trading that is often over looked, ignored or simply avoided by the average trader, as at first glance it can appear to be a complicated and complex issue.
In reality, with some uncomplicated rules to guide us, it is essentially a simple concept, which is easily grasped by both novice and more advanced traders alike, and the simplest way to explain it, is with some straightforward examples, which I hope will clarify this issue, which as I said earlier, many forex traders simply avoid!
As forex traders, or indeed when trading any other market, our guiding principle is to protect our trading margin at all times, and the reasons are very simple. If we lose 10% of our trading capital then we have to recover 11.1% in order to return to our original starting point in terms of our capital. If we lose 30% of our capital we have to recover 43% to return to our original amount, and if we lose 50% then we have to double our remaining capital – an almost impossible task. So, protection of our trading capital lies at the heart of all good money management rules in trading.
Protect your trading capital
If we start with our trading capital and look at it in percentage terms, then the maximum we want to risk on any ONE position is 1%, and this is an absolute maximum. In reality, this should be as low as possible, and even 0.5% or 0.25% are better, if this can be achieved whilst still making trading a viable option with your current trading capital. So what does this mean? Well in simple terms, if we take the 1% figure as our maximum, this means that we can be wrong 100 times before we are out of the market and have lost all our capital. If we reduce this to 0.5% then we could be wrong 200 times, and so on, and I should stress at this point that professional forex traders not only trade with VERY low leverage, or even no leverage at all, but will also aim to keep their risk on each position to the absolute minimum, and certainly in the 0.25% to 0.5% area. However, for the purposes of the following examples we’re going to work using 1% to keep the maths simple!
Let’s look at some examples
Let’s start with a small forex trading account, which has $1,000 and therefore based on our trading rules, the maximum we are going to risk on each trade is 1% of this, which is $10. Now, with this in mind let’s equate this to a position size in the forex market, and use a simple example based on the eur/usd pair. Now we know that with a mini lot, each pip movement in the pair equates to $1 move, either positive or negative, so in terms of placing our stop loss using this size of contract, AND to adhere to our money management rules, the maximum distance that any stop could be from our initial position would be limited to 10 pips, equivalent to $10 – hardly practical if we were trend trading, and certainly borderline and very restricting even for intra day trading or scalping.
Such a tight stop loss would result in a series of losses, simply by virtue of the stop loss being so tight to the market with no room to breathe. So, what’s the answer? The answer is to look at our contract size and scale down, as clearly our trading capital does not allow us to create sensible positions, based on our capital and our money management rules.
What if we consider a micro lot, which is one tenth the size of a mini lot? Well, in this case, a 1 pip movement is now equivalent to a $0.1 to 10 cents, so in this case, and applying our money management rule again, then this would allow us to have a stop loss at 100 pips, or 100 x $0.1 = $10. In other words, our money management rules are now dictating our position size in the market in conjunction with our available trading capital. In this case we can see that in order to meet our money management rules, and based on our trading capital, we should ONLY be trading in micro lot contracts, which we can then trade with sensible stop loss positions, either on an intra day basis where they might be 15 or 20 pips, or longer term trading, with perhaps a 70 or 80 pip stop loss, BUT all within our money management rules of a maximum of 1% risk per trade.
Now let’s take another example, this time with an account funded with $10,000 and once again apply our money management rules of a maximum risk on each position of 1% of our trading capital, or $100. Well in this case, if we take the mini lot contract and the eur/usd again, then 1 pip equates to $1 and therefore a 100 pip move would be our risk maximum, and a such we would clearly be able to trade both on an intra day and longer term basis, and keep well within our rules but this time using a mini lot contract. Alternatively of course, if we were trading an intra day position, with a stop loss of 30 pips, then we could happily trade three contracts, giving a total risk of 3 x 30 = $90 on the position, but once again keeping within our rule of a maximum loss on each trade of 1% of our trading capital. We may of course decide that we only want to risk one contract on this position which would reduce the risk to $30 or 0.3% of our capital, and so reduce our risk to those levels used by professional forex trader.
Scaling up in position size
Finally of course we could scale up to a full size account of perhaps $50,000, and here our 1% rule would be equivalent to $500 per trade, where we might be looking at a full size contract with each pip movement worth $10, and therefore a 50 pip stop loss would keep us within our trading rules once again, but only using one contract. The alternative of course would be to trade multiples of mini contracts which would keep us well below the 1% rule, and also allow for scaling out of a position which is an excellent way to take profits off the table as a trend develops.
In summary, the golden rule of all trading is ALWAYS protect your trading capital at ALL times, and NEVER expose more than 1% on each position. Whatever the size of your account, this rule ALWAYS applies, and should NEVER be broken under any circumstances, and even though you may only have a small capital base, this rule is equally valid, and perhaps even more so, as you look to build your experience, knowledge and expertise whilst protecting your most precious asset – your trading capital ALL the time.