Most people who approach trading discard Money Management as it is less attractive than indicators, systems, and practical trading techniques. Nevertheless, this is the core foundation of trading success. Without solid money management it even the best trading system will cause losses. It is important to know the basic truths of Money Management as they are the core of any probabilistic endeavor.
The outcome of any single trade is unknown
The outcome of any single trade is unknown. Each outcome – profit or loss – has a certain probability for occurring. The conclusion from this truth is that streaks of losing trades will occur, even if your trading system is profitable. The purpose of money management is to make you survive the streaks and able to recover quickly.
First principle of money management:
Risk a constant amount of money on each trade
I recommend risking 1-3% of your money on any single trade. Following this principle, even if one suffers 10 consecutive losses, he will only lose 10%- 30% of equity and would be able to continue taking trades and eventually recover. Most people risk 5-10% on each trade. This is a strategy that will inevitably lead to margin call – as even the best traders sometimes suffer from streaks of 10 consecutive losses. When these streaks occur, it will eliminate profits of many successful months or even years if improper Money Management is used.
This is an important issue many traders tend to forget. A fellow trader of mine is an exceptional trader. He had months with 1000 pips profit, and he doubled his account almost each month. After few months of trading with immense success, he developed an attitude of a total winner.
This was a double-edge sword: It gave him confidence in his analysis which is crucial for traders, but it also led him to believe that he is the market. He forgot the main principle of Trading, that each trade is a probabilistic event.
His trade size grew gradually until he risked 30%, even 40% of his entire equity in single trades. Despite his exceptional trading abilities, he eventually ended up broke.
I will now describe a popular method of money management that is accepted by investors and traders, though it is mathematically proven to diminish your account. I am talking about Martingale – also known as Averaging and Doubling-Down.
The basis of this method is doubling the trade size after each loss, so in case of profit, it will cover all previous losses. This strategy's origins are traced to gambling.
This money management system attracts many novice traders because it seems to be the magic cure for their trading illnesses. I will now demonstrate how destructive this method actually is. Let's assume you risk 1% of your equity on a single trade – very conservative approach. For each loss, one doubles his trade size, in order to compensate for previous losses.
It takes only 7 consecutive losses to drain all money from trading account. It may seem a distant, improbable event, but even one has 60% win percentage (and most traders do not), it takes just 245 trades for such an event to happen. Eventually, the evaporation of money is inevitable.
This leads us to the second principle of money management:
Do not change your trade size
No matter how many losing trades occur one should keep his trade size constant. The constant trading size will eventually lead to recovery. Most traders, when faced with streak of losses, will decrease their trade size because of fear, or increase it – to compensate for their losses. I strongly advise you not to follow this course of action.
These are the core foundations of Money Management. Remember these principles and do not deviate from them, in any circumstances. Even if you change the type of signals you trade, or choose to follow a system of your own, these principles should be left intact in your trading arsenal.
Let us summarize them up:
The outcome of any single trade is unknown
Risk a constant amount of money on each trade
Do not change your trade size
Now, when we have the foundations, we shall proceed to learning the core of our trading system – Chart Patterns.
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