New traders are often surprised to learn that when it comes to becoming profitable over the long term, controlling risk is just as important as making good trades. Risk, position sizing, and money management are no less important than trade entry and exit strategies, and should all be considered scientifically and thoroughly. If you get them right, then as long as you can maintain a trading edge (which is not very hard, as there are a few well documented trading edges), you have a solid blueprint for making a lot of money. You don’t need to pick spectacular trades to make a lot of money, you just need to keep consistently doing the right thing, and let the magic of compounded money management snowball the growth of your account equity. To get it right, start by asking a few basic questions.
How Much Money Should I Put in my Trading Account?
You have opened an account with a broker, and you are ready to start trading. You just need to deposit some cash. How much should you put in? You must be honest with yourself, and consider how much cash you have which is available for building wealth. You should not include assets such as a house or car in that calculation, or pensions: the question is how much free cash can you get your hands on, without debt, and use to try to increase your wealth? Once you have this number, you should be prepared to place no more than 10% or maybe 15% of it into something risky, like trading Forex. This might seem like a very small amount, but it really isn’t – please read on and I will explain why.
The Risk “Barbell”
Imagine there are two traders, Trader A and Trader B. Both have $10,000 in liquid assets, which is all the ready cash each of them can get their hands on and use to build wealth. After opening brokerage accounts, Trader A funds his with his entire $10,000 while Trader B funds hers with 10% of the same amount, $1,000, while placing the remaining $9,000 in treasury bills guaranteed by the United States, which pay a low rate of interest.
Consider their respective positions. Trader A will be at a psychological disadvantage, as the account represents all the money he has, so losses will probably be painful for him. He should also worry about the broker going bankrupt and not being able to get any of his funds back, unless the broker is backed by a government deposit insurance program. Even then, his money could be tied up for more than one year before he gets any insurance. Due to his fears, even though he knows the best risk per trade for his trading strategy is 2% of his account equity per trade (more on how to calculate that later), he decides to risk less than this. He decides to risk only one-tenth of the full amount, so will risk 0.2% of his equity on each trade.
Trader B feels much more relaxed than Trader A. She has $9,000 very safely parked in U.S. Treasury Bills, and has $1,000 in her new brokerage account. Even if she loses the entire account, at the end she would only have lost 10% of her investible wealth, which would not be fatal and could be recovered. It is drawdowns exceeding 20% that are a challenge to recover from. Trader B is more psychologically prepared for risk than Trader A is. She calculates that the optimal risk per trade for her trading strategy is 2% of her account equity per trade, just like Trader A, but unlike Trader A, she is going to risk that full amount.
Both Trader A and Trader B are going to begin by risking the same amount per trade in cash, $20. Below is a graph showing how their account equities will grow if they each follow their money management plan and win 40 consecutive trades (which is very unlikely to happen in real life).Trader B, with the smaller $1,000 account and the $9,000 in T-bills, ends up with a total profit of $811, of which $117 is interest received at the end of the year on the T-bills. Trader A, with the larger $10,000, ends up with a total profit of $617. Even though they start with the same risk, diversifying risk capital between conservative fixed income and something much riskier, pays Trader B a significant benefit, and gives her the peace of mind to be as aggressive with risk as she should be.
How Much Money Should I Risk Per Trade?
This is an easy question to answer, if you know the average or median amount of profit you can reasonably expect to make on each trade, and you are concerned only with maximizing your total long-term profit: use a fixed fractional money management system based upon the Kelly Criteria (a formula which will be explained in detail in the next paragraph). A fixed fractional system risks the same percentage of your account value on each trade, as we showed in the earlier example of Traders A and B who were using 0.2% and 2%. Fixed fractional money management has two big advantages over other strategies. Firstly, you risk less during losing streaks, and more during winning streaks, when the effect of compounding really helps build up the account. Secondly, it is theoretically impossible to lose your entire account, as you are always risking X% of what is left, and never all of it.
The final question is, how do you calculate the size of the fraction to risk? The Kelly Criteria is a formula that was developed to show the maximum amount which could be risked on a trade and would maximize long-term profit. If you know your approximate odds on each trade, you can easily calculate the optimal amount using a Kelly Criteria calculator. In good Forex trading strategies, the amount suggested by the Kelly formula is typically between 2% and 4% of account equity.
A word of warning: using the full amount suggested by Kelly is bound to lead to huge drawdowns after losing streaks. Some fine traders, notably Ed Thorp, have suggested using half the amount suggested by a Kelly Criteria calculator. This generates 75% of the long-term profit, but only 50% of the drawdown, produced by the full Kelly Criteria.
Money Management is Part of the trading “Holy Grail”
It is no exaggeration to say that the major reason why traders still fail even when they are following the trend and getting their entries and exits mostly right, is because they are not following the risk and money management techniques set out here in this article, as part of a comprehensive trading plan. Forget about the result of the trade you take today, and worry instead about the overall results of the next 200, 500, or 1000 trades you take instead. If you can make a profit of only 20% of your risk on average per trade, which is feasible using a trend-following volatility breakout strategy, it is quite possible to turn a few hundred into a million within ten years. Here is a simple guide to learn forex trading.