Money Management

Many successful traders will tell that there is only one guarantee in trading, which is if you trade, you will have losing trades. There is no way around this point. Many successful trend traders win less than 40% of their trades. The reason these successful traders are profitable when losing so many of their trades is Money Management. If finding the strongest trend to trade is the key to successful trading, using a solid money management approach may be a very close second in terms of importance. As a matter of fact, there are traders who are convinced that without a solid approach to money management, a trader has little chance to be consistently profitable. The key is to cut your losing trades quickly and to let your profitable trades run for as long as possible. This of course, is usually the opposite of how most new traders manage their trades. They have a tendency to let the losing trades run as they hope the market comes back to profitable territory or to close their winning trades early before they become losing trades. If you lose more on your losing trades than you win on your winning trades, you have to win more just to break even. The relationship between your initial risk and profit target is the risk:reward ratio we mentioned in the previous lesson.

Risk:Reward Ratio

Here are some examples of risk:reward ratios and how they can influence your trading results:

• If you risk 100 pips and look for 300 pips in profit, your risk:reward ratio is 1:3 or one pip of risk for every three pips in potential profit. A win percentage of 25% is needed to break even.
• If you risk 100 pips and look for 200 pips in profit, your risk:reward ratio is 1:2 or one pip of risk for every two pips in potential profit. A win percentage of 33% is needed to break even.
• If you risk 100 pips and look for 100 pips in profit, your risk:reward ratio is 1:1 or one pip of risk for every one pip in potential profit. A win percentage of 50% is needed to break even.
• If you risk 100 pips and look for 50 pips in profit, your risk:reward ratio is 2:1 or two pips of risk for every one pip in potential profit. A win percentage of 67% is needed to break even.
• If you risk 100 pips and look for 25 pips in profit, your risk:reward ratio is 4:1 or four pips of risk for every one pip in potential profit. A win percentage of 80% is needed to break even.

But of course, the goal is not to break even but rather to be consistently profitable. We do recommend using the 1:2 risk:reward ratio and to think about winning half of your trades. By trading with the trend and looking for more in profit than you are willing to risk, you can increase your chance of success in trading and that is what money management is all about.

Margin and Leverage

There is another aspect to money management other than the initial risk on a trade. You also have to decide how large of a position to open. Margin is a good faith deposit placed by the trader when opening up a new trade. The margin requirement is a small fraction of the position size. An example would be a $10,000 EUR/USD trade would only require a margin of $320. While this use of leverage allows the trader the opportunity for big profits on a modest account balance, there is also the possibility of big losses. Many experienced traders risk no more than 5% of their account balance at any one time. Whether that means opening one trade risking 5% of looking to open five trades risking 1% each is up to the trader. But one of the keys to successful trading is to limit your risk and to let the profits take care of themselves. If you have an account balance of $5,000, you should risk no more than $250 at any one time. This allows the trader the ability to remain trading even after suffering a losing streak. Don’t let one or two trades knock you out of the game. Being a consistently profitable trader takes some time, but by limiting your risk, you give yourself a better chance of gaining that experienced needed to move up to the next level of trading.

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