Money Management

When you make a trade, most people only think about earning potential, but we must not forget the loss factor. It must be incorporated into your trading strategy. The money management is actually management of risk or capital management. On the Forex, the risk comes mainly from the leverage that we use. Whether you have a big account or not, if you use a too high leverage this will lead one day or the other to an account at 0!

The money management will therefore limit your risk from an adjustment of the size of positions, the management of stop loss, the risk / return ratio and finally track your position until the end of the trade.

Calculation of position

Calculate the amount of your position allow you to limit your risk to a certain percentage of your capital. Whatever the size of your account, it is also advisable to operate in % and not amount. <

Before getting into position, you must determine two things:

1. What percentage of your portfolio are you willing to risk on this trade (to eventually find out the corresponding amount)
2. Where are you going to set up your stop loss stop (at how many pips of your entry point)
3. Once these two elements known, the formula is very simple:

Amount = higher risk in the currency traded / number of pips to the stop

Example : EUR / USD is priced at 1.4200. We want to risk \$ 1,000 on 100 pips.

So, we take a position of:

1000 / 0.01000 = 100,000 Euros.

So 1 pip worth 10\$

NB: It is possible to settle your highest risk in the base currency of your portfolio, but the final result of the trade will be approximate. Why? Because if for example you trade on USD/CAD (Profit or loss in CAD) and the base currency of your portfolio is the Euro (currency used here for the max risk), the EUR/CAD parity will necessarily move during your trade.

We are going to take a new example to illustrate all this:
Portfolio in Euros. Long position calculated on 100 euros of max loss, stop loss at 50 pips.
USD/CAD priced at 1.2000/05. So Long open at 1.2005.
EUR / CAD priced at 2.0000/05.

Calculation of the position: (100 euros * 2.0005) / 0.0050 = 40,010 USD

Next, the price of USD / CAD fall and we are stopped at 1.1955 (50 pips). But during that, the EUR / USD for example went to 1.5000 / 05 (extreme case)
We had set a maximum loss at 100 euros. In this case, our loss is:

((1.2005 – 1.1955) * 40.010) / 1.5005 = 133.32 euros.

It is therefore preferable to set the maximum risk in the currency of the Trade. (Here: CAD for our example). Obviously, the EUR / USD which decline from 2.0 to 1.50 it’s not all day. But, when dealing over a long term period and if you use a high leverage, it can have consequences. Manage risk in currency of the trade has the advantage that we know precisely the amount of your loss if we are stopped.

Once in position, you must then seek to maximize your profit. If the price is going in the right direction, you will then move your stop according to the price moves and not exit the trade on a little profit (the movement can be perhaps at its beginning). But where to move your stop?

You can move your stop on a last higher / lower, on a Super Trend, or other … (Ask on the forum) But always remember to look at the price offered if you are Short, and asked Price if you are long because the spread is often overlooked in the setting of the Stop. It is also advisable to add / remove a few pips to your stop in order to not be bang stupidly. (Indeed, if for example you’re Long, last lowest asked price at 1.4210, do not set your stop at 1.4210 but just below. This prevents outputs on double Top or Double Bottom)

As I said, the trader’s objective is to maximize its profits. This also requires strengthening your position if the price is going in the right direction and this is what we called ‘pyramiding‘ (used in the Dow Method). For example you’re bullish on the EUR / USD and the price rises. Next a corrective movement occurs and once you feel that the correction is over, you take another long position on the EUR / USD. Then you must protect your earnings for the first position you have taken and limit your losses on the 2nd position in case the parity will go down. This is why as far as the price is going in your side, we are going to move your stop loss to protect your profits.

The risk / return ratio

Before getting into position, it is necessary to determine a price target. (Even if the output of the trade will not occur necessarily on target but I shall return to this concept later). Indeed, according to the remoteness of the price compared to your target and your stop, you will determine if the trade worth the case or not. This is called profit expectancy.

In the calculation of this ratio, the risk and return are expressed in number of pips. For example, your stop can be at 20 pips and your target at 60 pips. The ratio is 1 / 3. This means you need to be right on 1 / 3 of all your trades to not lose your capital. More the ratio that you impose on you will be high, the more it will absorb the errors of analysis that you have committed. However, a too high ratio limits your number of opportunities. In fact, if you see an interesting trade, but the risk / return ratio is 1 / 3 but you impose on you 1 / 4 then you need to not enter into the market.

Generally, it is estimated that a ratio of 1 / 3 is interesting. More you are a beginner, more it is advisable to take a high ratio because your error analysis are usually more frequent than a professional trader.