At the core of any competent trading strategy is a well thought out and tested money management method. When properly crafted and applied, there is no better indicator for giving each entry the highest probability of successfully resulting in the optimal position size.
When the optimal position size is reached and backed up by a great money management plan, you give yourself one of the best possible safeguards against default and unforeseen future market moves which might negatively impact your account.
Three ways we can approach a robust money management method :
This is very simple but also quite unreliable. This is the cavalier method of entering each trade with a fixed position size. So, regardless of the market conditions, there is little or no consideration for the amount of capital in the account or percentage of capital.
While this method might hit a few times, over the long run it is guaranteed to create serious troubles for your account. The main problem with this method is that by not taking the account size into consideration, a trader cannot predict how much money they are going to risk before entering into the trade. This means that one bad move could wipe out an entire account.
If however, you do want to follow this method, it is important that market entry and exit points are always determined and the calculated risk/reward ratio is low enough not to gut the account in one trade.
This involves calculating risk (in contrast to the first method). When a trader approaches a trade with a fixed risk size, they always know how much risk they are taking on before they enter into a trade.
The first step to determining a fixed risk size is determining what you’re willing to risk per trade. Let’s say you decide that your risk per trade is $20. The next step is to determine the risk in points, let’s say 150 pips. The last variable is the rate value of each contract of a currency pair, let’s say you mark it at $1.0000.
With these numbers in place, the formula for determining the fixed risk size is as follows:
S (position size) = R (desired risk) / S (stop-loss size in pips) x P (pip value for a contract)
Inputting our hypothetical figures from above, we would get:
S = 20 / 150 x 1
S = 0.1333…
In this example, at a risk of $20, the position size needs to be 0.13 contracts. While the formula stays the same for each trade, the contract size will change depending on how the variables shift from trade to trade.
The first thing you need to consider with this method is when proceeding towards making a trade, is asking yourself – what share of capital are you willing to risk in the trade? This means that in the beginning, the risk will be fixed as a percentage of the trading account.
With sufficient capital, the position size will continuously shift. As you progress, you’ll soon notice that the lower the possible position size is, and the larger the capital is, the easier it will be to calculate position size.
As a general rule though, it’s unwise to risk more than 1% of your capital on any given trade. This means you should avoid losing more than 1% of your account on any trade.
This doesn’t mean that you can only trade with 1% of your capital. Many traders utilize leverage to go well beyond 1% of their trading capital. For more info on leverage, check out our article here.
If you shift your thinking of money and risk towards an understanding of the percentage of capital, you may be able to spare yourself a lot of the hardship and loss that many traders experience on a daily basis.
When others see their accounts crashing, you can be inoculated from such loss because your risk was never too large to be unable to absorb unforeseen losses. With a good money management plan and a little bit of discipline, there is no circumstance that you unable to overcome.
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