One of the biggest misconceptions novice traders have, is to think that trade entries are the only element worth considering, and the only factor that will decide if the trade is profitable or not. They often pay little attention to exit strategies and even less to money management.
Successful traders focus on money management and risk control first, while unsuccessful ones devote their full attention to trying to find the perfect entry. This article will provide you with a sound and proven money management system, which will allow you to trade consistently, always taking into consideration the underlying market conditions. Correctly calculating position size based on volatility is a key skill to have if you want to succeed in trading. At the end of the article there's a link to download this system.
► The adaptability of cockroaches and why you should be like one
Cockroaches are one of the most adaptable creatures on our planet, and they've been around for 250 million years. The reason why they were able to survive in different climates and environments is because they have simple behaviour patterns which can be adapted to different ecosystems.
Complex creatures, on the other hand, usually have rigid behaviour patterns, and when something drastic happens to the ecosystem they are not able to adapt themselves and they get extinct. Adaptability = survivability in the long run
Your objective, as a trader, should be to become a cockroach, if you want to be successful in the long run. So rigid rules such as always trading the same amount of units regardless of how much capital you have, or using a fixed stop loss of X pips all the time ignoring the prevalent market volatility are not correct. Your system should have as many variables as possible, and as few constants as possible. That's the only way to ensure that you will survive different market conditions, just like a cockroach.
► Typical money management mistakes traders make, when using rigid rules
- Trading a fixed amount of units no matter what currency it is, so they'll trade 1 million GBP/USD, 1 million NZD/USD, 1 million EUR/USD, thinking they are being consistent by trading the same in various currencies, even though 1 million GBP = 2 million NZD, so there's no consistency at all.
- Trading a fixed amount all the time regardless of volatility, so they'll always trade 100,000 EUR/USD, irregardless of the market being calm or extremely wild.
- Using a fixed stop loss/take profit of 50 pips (for example), again completely disregarding volatility. For example, if the market has been too volatile and the ATR is 500 pips, then your stop loss can be prematurely activated.
- Trading a fixed amount of units even if they've lost most of their initial trading capital. Once again, misguided "consistency". You should trade based on the capital you have now, not the capital you USED to have.
Currency pairs do not share the same behavior, some are very volatile, like the NZD/JPY, while others don't move that much, like the EUR/GBP. Also, a pair can exhibit extreme volatility one week, and be very stable the next one. By lowering the amount you trade when a pair is volatile, and increasing it when it is calm, and at the same time changing your stop-loss/profit targets, it allows you to be in sync with the market and to always have the same risk and profit potential on the table.
This is what volatility normalization is all about, treating different market conditions and currency pairs differently, in order to make them all the same in the end. You'll no longer say "currency X is riskier than currency Y", because all pairs have basically the same risk once you normalize the volatility.
► Building blocks for a solid and adaptable money management system
We'll use the following variables:
- Direction; direction of the trade, can be either L (for long) or S (for short).
- Spread; typical lowest spread of the currency pair you will trade.
- Price; price at which your order will be triggered, assuming you use conditional orders (preferred).
- ATR; Average True Range is one of the main ingredients of a money management system. This indicator, available on all trading platforms, is a measure of volatility of the past X periods. ATR 10, 14 or 20 are commonly used.
- ATR Stop-loss; stop-loss in multiples of ATR. Let's imagine that the typical ATR for the time frame you're interested in is 80 pips, and that you'd like to place the stop 40 pips from the entry price, then the value of this variable will be 0.5. If the pair becomes extremely volatile and the ATR changes to 300, then the stop-loss would reflect this and change to 150 pips (you'd also trade a smaller amount). If the volatility falls to 20, then the stop-loss will be only 10 pips (and you will trade a larger amount to compensate for the lower volatility).
- ATR Profit; profit target in multiples of ATR. Similar to ATR Stop-loss.
- Account balance; that's the trading capital you have now, not the money you deposited when you opened the account.
- Risk; risk per trade in percentage points. There is no correct value to enter here, it depends on many factors such as the number of currency pairs you trade at the same time, their correlation, the win ratio of your system and your risk appetite. If you usually only have one position open then 1% to 5% is acceptable.
- Account currency/base currency. If, for example, you've opened a euro denominated account on Dukascopy, then EUR will be the account currency. Base currency is the first quoted currency in a pair. If you wanted to trade USD/JPY, the base currency here is the USD. Taking everything into consideration the value of this variable would be the price of EUR/USD, or 1.2850, for example. Using the trading contest as an example, where the account currency is USD, then B would be the price of USD/USD, which is obviously 1. If you wanted to trade EUR/USD in a USD denominated account, this variable would be the price of USD/EUR. You can divide 1 by EUR/USD to get the USD/EUR value. So 1/1.2850 would be 0.7782.
► Putting it all together on a spreadsheet
I have created a calculator on Excel that will allow you to easily and quickly calculate position sizing, stop loss and take profit orders, according to market volatility and capital available. You just need to insert all the variables and the calculator does the rest for you, you don't need to type any formulas. This is how it looks like:
The variables shown here assume that the trader wants to go long EUR/USD once the bid price reaches 1.2850, the typical spread is 0.00006 pip, the ATR is 80 pips, the stop loss uses one unit of ATR (80 pips), the target profit is set at 2.5 units of ATR (200 pips), the account balance is US$100,000, and the trader wants to risk 2% ($US2,000) on this position. This is all configurable to suit your needs. The calculator then indicates the order levels and the amount that should be traded: 248,000 EUR/USD. It also shows the correspondent amount in the account's currency, USD.
Even though you can simply download the spreadsheet and start using it right way without knowing any formulas, the most important one is the formula that calculates how much you will trade. This is the mathematics behind it:
The process to calculate the stop-loss and take profit orders is very simple. You'd just need to multiply the ATR by the chosen multiplier, and then add or subtract the result to the entry price. The types of orders used follow the recommendations described in my August article, How to Avoid Being Stopped out when Spreads Widen.
The calculator can be downloaded HERE.
There are other systems to calculate position sizing, but most of them share a common problem: they were originally developed for gambling, not for trading, like the Kelly Formula. In gambling, you can calculate with mathematical certainty the odds of winning, but that's not possible in trading, no matter how well you have tested you systems, so those formulas should not be used for trading. Not only do they make you take excessive risks, they also do not take into consideration the volatility, so that's why I created my own formulas.
Money management is not merely an important factor, or even as important as trade entries, but it is actually THE most important factor in trading, do not neglect it.
Feel free to leave a comment or ask any questions you may have.