IF WE traded with a fail-proof trading system, money management would be easy. We would simply risk as much as possible to maximise our gains. Yet real-life trading is very different. Studies show that the average FX trader makes a positive return on 60 out of 100 trades on average.
As a simplified example of how this might work, let’s assume that the first 40 trades are losses and they are produced in a row. After the 40 losing trades, we would generate 60 gains.
In the most extreme case, if we risk all our money on each trade, we will not be able to make it past the first one. This is clearly too extreme for all trading systems. In a less risky example, we might risk losing 2.5 per cent of the account on each trade. We would then be able to trade 40 times, but that would be the end of the account and we would not be able to reap the gains. A 2.5 per cent maximum loss on any trade is the upper limit in this scenario and, ideally, we wouldn’t trade with a system that generates 40 losses in a row.
So what risk am I willing to trade with? I am sticking to about a 1 per cent maximum loss per trade for an intraweek position, and I might trade up to two times per week. In situations where I have a strong case and am willing to hold the position for a month, I will risk up to 4 per cent of the account. The stop will be adjusted according to the expected volatility over the holding period.
And this is what money management is: risking enough to make it worthwhile trading, but also making sure that we are able to survive inevitable rough patches.
For any questions or ideas, reach out via www.twitter.com/AlexFX00
Alejandro Zambrano is a currency strategy analyst at DailyFX.com.