Money management in a nutshell. Part 1 - Page 94
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  1. #1
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    Money management in a nutshell. Part 1

    Hi traders. I’ve looked over the forum and haven’t found any decent thread about money management and this topic is not just important. Proper money management distinguishes survival from failure.
    I see too many traders with enough experience who continue blowing up their accounts over and over again just because they fail to manage their capital properly, they take too much risks for their positions.

    Why is this important?

    You may ask – if my trading system is good and I can generate good entries on consistent basis, why I should care much about this? I can take high leverage and earn money, that’s how it works, isn’t it?
    No. Our ability to predict market moves or even be right more than 50% of the time is limited naturally. By accepting this fact you recognize that in your trading you WILL have drawdowns. You will have losing days, weeks and months (I hope, not years, but it is also realistic). And you have to be prepared. Of course, you will do everything to reduce your drawdowns, to adapt your strategy or trading plan to changed market conditions, but drawdowns are the part of the game – one can’t sustain permanent growth without corrections.
    Once you accept the fact that your abilities to predict market action (as well as any other person’s abilities) are limited, you come to importance of money management. You need to survive.

    Mathematics of survival.

    Let’s assume that we use very simple money management principle – in each trade we risk certain amount of capital, say – 2, 3 or 5%. If you had, say, 1000 USD at the beginning of this process and put 5% at risk, you will have 950 USD if you are stopped out of your position. After that, you will be able to risk only 950*5% = 47,5 USD and so on.

    In a graph shown below you see quantity of losses that you can possibly have before losing entire capital. Of course, it’s just theoretical graph – it doesn’t take into consideration lowest possible trading size, margin, spreads and commissions. But it shows that when your raise your lot size, you decrease robustness of your trading in non-linear way. Having 6% of capital at risk is more than 2 times riskier that having 3%. Having 10% at risk is more than 2 times riskier than 5%.

    Attachment 10666

    To survive possible tough times, your trading needs to have enough level of robustness. Even if you flip a coin, you will have greater chances of survival if you apply appropriate money management rules. But if you analyze the market and achieve good profit/loss ratio, you would expect not only to survive but also to have your equity curve going forward.

    Martingale:

    The easiest way to blow up your account is applying martingale principle. You increase your lot size twice after being stopped from the position. In this case you have basic assumption that market will inevitably return at least to a point where you opened your first position. You average your loss expecting to cover it if price returns. In most cases it works, it may even work for some long period of time, but in case of directional break, your losses will inevitably exceed your available margin – thus, your account will be liquidated. «Not for me, not this time» - this is a prayer of every martingale trader.

    Attachment 10667

    Fixed proportion method:

    That’s the simpliest money management principle. You just take 2-3% of your capital (or whatever) and calculate it from your available margin (deposit size). When size of your deposit decreases, you also reduce your size, when it increases, you slowly increase your size.
    Every money management principle has it’s benefits and drawbacks

    Benefits:

    Robustness, ability not to lose much in case you experience unexpected drawdown

    Drawbacks:

    Slower recovery. If you would risk fixed fraction in your trade (say, fixed amount in dollars), you would recover more quickly in case of drawdown. But of course, in this case you would accept greater risks

    Fixed fraction method:

    In this case you simply put predefined amount in dollars at risk in each trade. If you start with 2000 USD and decide to put 100 USD at risk in each trade, you are not expected to change this trade size even if your equity goes down. But you should increase your lot size as your equity curve goes up.
    This money management principle is the most aggressive and definitely not recommended for beginner traders.
    Your leverage will increase as (if) your equity goes down and your risks too.

    Benefits:

    Quicker recovery from drawdowns

    Drawbacks:

    Relative loss size (and risk) increases as equity goes down

    To be continued…

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  2. #931
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    Quote Originally Posted by erespe View Post
    With martingale technique, we double the possibility for profit but also double the possibility of losing money. Make sure that before choosing this strategy, we must already really understand the workings and risks. Of course we can not ignore the power of margin that we have when using this strategy, so when our margin is minimal, you should never use this strategy.
    Yes with the martingale both profit scopes and loss scopes are increased and hence even these decisions should be taken in accordance to our risk management rules. I think good and cautious trading is achieved only when both risk management and analysis is combined. Risk management is the heart of successful trading. If trader wants to be skilled, then that trader has to practice and focus on good work always.

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  3. #932
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    Quote Originally Posted by AmitChallenger View Post
    Yes with the martingale both profit scopes and loss scopes are increased and hence even these decisions should be taken in accordance to our risk management rules. I think good and cautious trading is achieved only when both risk management and analysis is combined. Risk management is the heart of successful trading. If trader wants to be skilled, then that trader has to practice and focus on good work always.
    You have mentioned it rightly, every trader has to trade in Forex giving due importance to risk and money management. When these are followed with discipline, we can create a calm and stress free environment for ourselves so that we can take the best possible decisions. In most cases stop outs only point towards the traders inability to manage their risk properly.

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  4. #933
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    Quote Originally Posted by Abhishekwala View Post
    You have mentioned it rightly, every trader has to trade in Forex giving due importance to risk and money management. When these are followed with discipline, we can create a calm and stress free environment for ourselves so that we can take the best possible decisions. In most cases stop outs only point towards the traders inability to manage their risk properly.
    As I have experienced, the main problem of traders who are lack of risk management is because they don't did a good plan, we need a test (back test or forward test) in order to know our risk , reward, and the quality of our trading strategy. After we know it, then we've got the data in hand, this will automatically make our psychology better or reduce the pressure psychologically.

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  5. #934
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    Quote Originally Posted by Abhishekwala View Post
    You have mentioned it rightly, every trader has to trade in Forex giving due importance to risk and money management. When these are followed with discipline, we can create a calm and stress free environment for ourselves so that we can take the best possible decisions. In most cases stop outs only point towards the traders inability to manage their risk properly.
    You are very right , I'm sure traders who are able to apply Money management wisely already know the risk control on every transaction done, but what traders need to know is how to keep consistency in implementing them in order not to trade with lots size that do not count wisely until eventually the traders even go into losses.

    Therefore do not ever feel greedy to want to get profit as much as possible in a very short time because it is part of the risk taking is too high which ignore the implementation of good money management

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  6. #935
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    Martingale is not the best strategy in money management for me. This could been risky so much in trading. Except the amount enough big to defense in market, but my experience about martingale without full calculating and less the discipline to plan trading, this is very risky.

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  7. #936
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    Sometimes, traders may perceive forex trading as gambling since trading can be associated with many uncertainties and riskiness. But to be a survivor each trader must try to secure his trading performance because forex being a financial market is full of perils here. However, yes, when a trader can’t make certain competent money organization and risks organization to prevaricate riskiness and protect his wealth position in efficient manner then trading can resemble to gambling here.

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