MONEY MANAGEMENT - How NOT to Lose Your Shirt (Part 2)

Let's start with a concrete example. If we take a look at this chart again of the EUR/GBP we see it is caught within a descending channel, trading up near the resistance.

Let's say we decide to enter a SHORT trade if the next candle that prints is bearish (red). I'm not sure why but the currency prices have been cut off. Let's assume we eventually enter the short at a price of 0.6740. We decide to place our protective stop loss at some point above the resistance line, say, at 0.6770. Our profit target will be set at the bottom of the channel at approximately 0.6620.

What does this translate to?

We are taking a 30 pip risk (0.6740-0.6770) for a potential gain of 120 pips (0.6740-0.6620). This is a reward:risk ratio of 4:1, meaning we stand to gain 4 pips for every 1 pip of risk. This is a fabulous ratio! How do we decide how many contracts or lots we trade on this trade then?

To figure that out we need a few pieces of information:
1. Account balance, which we will assume to be $ 7500.00
2. What percentage of this account do we want to risk on a trade (1% or $75.00)
3. What is our stop loss in pips: 30 pips

Then we plug that info into this nifty little calculator:
» Adjust the position sizing Mataf.net:

What this will reveal is the maximum pip value you should be trading. The results show that each pip should be worth a maximum of $2.50 in order for you to lose a maximum of 1% should your stop of 30 pips be hit.

I'm not sure what broker you deal with so check their pip values for a single mini contract of EUR/GBP. It should be worth approximately $1.80 per pip. So that means if you trade 2 mini contracts on this trade, you will be trading a pip value of $2.60 - slightly over the recommended $2.50. So, it's best to be conservative and round down to 1 contract.

Play around with the tool and see the changes in pip values according to the parameters you enter.

The above money management methodology is called the Percent Risk Model. It is the one i like the most as it allows you to equalize your dollar risk no matter the size of stop you use. For example, whether if i have a trade on that has a 30-pip stop loss or a 100-pip stop loss, this model adjusts your position size accordingly so that your risk in dollars stays consistent all the time.

There are many other models of money (risk) management that you may feel more comfortable with but the important thing is that they all must be able to put the power of compounding returns on your side. Too many traders start trading and arbitrarily place single contract trades without regard to the power of compounding. I cannot say enough how powerful the impact is on your bottom line.

Which reminds me, i want you to have a look at these guys:

Trader's Club is a highly reputable training group/program for aspiring, struggling and experienced traders alike. They make no claims of instant riches, only that riches are within everyone's reach if you do the right things. Have a look and decide for yourself if they are right for you.

But if you do one thing, sign up for their FREE VIDEO SERIES on risk management. It will drive home everything i've said, only far more effectively. They will send you 4videos (1 per day) explaining all elements of the topic and how to properly implement the power of compounding returns. Specifically it illustrates through live account shots how a $1000 account grew to over $11,000 in about 1 year.

Finally, i strongly advise you to read through Van Tharp's book on the topic here:

This is an authoritative industry resource on system development and does a superb job of describing different money management (AKA position sizing) styles and the impact each style has on trading results. Check out the chapter on position sizing and read it over a few times. You will be stunned at how much of an impact it has on your results. No trader ever questions its importance after reading Van's work.