Showing posts with label calculations. Show all posts
Showing posts with label calculations. Show all posts

Understanding the Money Management in trading

I've always emphasized the importance of the MM in Forex, in my articles. Yet, many people failed to understand it properly.

Therefore I will take it, again, step by step from the basic theory.

Currencies Rates

The currency Rate is the value of one currency expressed in terms of another.

Common rates can be seen as: EURUSD = 1.3025

This can be read as 1 EUR = USD 1.3025

The first currency (EUR in our example) is the "Base currency" and the second one (USD in our example) is the "Quote currency".

Bid and Ask prices

EURUSD = 1.3025/1.3027

The first rate (1.3025) is the "Bid" and the second one (1.3027) is the "Ask"(Offer).

If you want to "Buy" the "Base currency" (EUR) and "Sell" the "Quote currency" (USD), you will use the "Ask" price.

If you want to "Sell" the "Base currency" (EUR) and "Buy" the "Quote currency" (USD), you will use the "Bid" price.

The difference between Bid and Ask is called Spread (in our example spread = 2 pips).


Pip = The smallest price movement on a currency. Also known as a "Tick size".
e.g. 1 pip = 0.0001 for EUR/USD, and 0.01 for USD/JPY.

Leverage & Margin

Leverage = multiplying factor that allow you to trade more money than you have into your account.
Margin = the amount of money, necessary to open a trade

Leverage 1:50   = 1/  50x100 = 2% Margin (requirement)
Leverage 1:100 = 1/100x100 = 1% Margin (requirement)
Leverage 1:200 = 1/200x100 = 0.5% Margin (requirement)

So let's say you want to trade $100,000. By using a Leverage of 1:100, that means you will need a margin of just $1,000 (1%).

Trading using the Leverage might work in your favor if you are right, but can also take you to the bankruptcy, if the trade goes against you.

Here is an example:

Trader 1 have Initial Account balance = $3,000
Trader 2 have Initial Account balance = $10,000
Trader1 use as Leverage = 1:200 = 0.5% Margin = $500
Trader1 use as Leverage = 1:50 = 2 % Margin = $2000

Trader1 and Trader 2, want to buy $100,000, each.

Scenario 1:
Lets say both traders are right and their trade work in their favor with +100p = + $1,000

For trader 1 = +33.3% from Account Balance
While for Trader2 = +10% from Account Balance

Scenario 2:
Lets say their trade went against them with -100 pips = -$1,000 from the Initial Account Balance.

For trader 1 = -33.3% from Account Balance
While for Trader2 = -10% from Account Balance

Even if for some traders looks more profitable to use higher Leverage, due to their small accounts, if their trades work against them, this will ruin their account. Ofcourse they might be tempted to use a high Leverage (smaller Margin) so they can trade a much higher volume.

Lot size

In Forex, we dont use Base currencies for the trade volumes. We use Lots.

1 Lot = 100,000 units (full Lot)
0.1 Lot = 10,000 units (mini-lot)
0.01 Lot = 1,000 units (micro-lot)

In our previous example is obvious that if the trade work against you, and you traded a huge volume, the loss is highly important, as the expected profit.

Trader 1 have 3 potential negative trades until he will ruin entirely his account. While Trader2, can afford 10 trades, for that.

You know what they say: "A rich man is a man who can survive longer, without having anymore income". Same as in trading. It doesn't matter how much you can pull out of a trade, but how many negative trades you can take and still be in the market.

Risk/Reward Ratio

Also known as R:R ratio, it means the ratio between expected profits and potential losses.
I don't recommend a R:R lower than 1:3. That means for any loss you might have, you must take at least (minimum) 3 times more from the profitable trades.

TP = 3 x SL

This isnt a random number. This is related to any strategy statistic.
You all know, that you can't have profitable trades, only. So your strategy statistic can be from 5-9/10 trades in profit:

  • min 5/10 since you can have 2 option on any market: buy and sell. So you can have 50-50% to be right on any trade. 
  • max 9/10 since you cant be right all the time.

So, in order to reach your profitable trades, you must be able (afford) to take those losses.

Ofcourse, I prefer to use a much more significant statistic for any strategy, like x/100 trades. Because this offer me a better understanding of the strategy on a longer period of time.
Imagine a 9/10 strategy might be less than 90/100 on a longer period of time (and trades).
What if those 10 negative trades will come, in raw, while starting to trade that strategy ?

Well, you must be prepared for that, as well. You need to still be in the market, when those profitable trades will come.

Money Management

I'm sure you all heard about "Money Management Rules". But what is this really means?

Well, you can consider it a "healthy" way to be in the market longer. Or how much negative trades you can take, in the worst case scenario.

For doing that you need to be able to calculate 2 main things: Volume (as no of lots) and Stop Loss (in pips) for your trades.

I wont develop here the calculations behind the mathematical probabilities of a strategy. All you need to know is that you should use these numbers, as beginner:

Max Risk/Trade = 2%
Max Investment = 15%

(take as example our previous exercise for the Trader1)

Example of MM Rules:

Account Balance = $10,000
Max Investment = 15% = $1,500
Risk = 2% = $200
Leverage = 1:100
EURUSD = 1.3025

How many lots can you trade?

1.0 lot = 100,000 EUR => Margin =1%=1,000 EUR =$1,302 (1000 EUR x 1.3025)

0.1 lot = 10,000 EUR => Margin =1%=100 EUR =$130

0.01 lot = 1,000 EUR => Margin =1%=10 EUR =$13,02

Lot size = Max Investment / Margin

Lot size = $1,500 / $1,302 = 1.15 lots (round it to 1.1 lots)

How much pips you can afford to lose ? (Stop Loss)
First we need to find out the pip value.

1 pip = lot size x tick size
( for Direct rates as: EUR/USD, GBP/USD, AUD/USD, NZD/USD )

1 pip = pip = lot size x tick size / current rate
for Indirect rates as: USD/JPY, USD/CHF, USD/CAD )

1 pip = lot size x tick size x base quote / current rate
( for Cross rates as GBP/JPY, EUR/JPY, AUD/JPY, EUR/GBP, GBP/CHF - where USD is not involved )

Examples by using the standard formula:
EURUSD = 100,000 x 0.0001 = $10
USDCHF = 100,000 x 0.0001 = 10 CHF
USDJPY = 100,000 x 0.01 = 1000 JPY

Then use these results vs your account currency rate, to find the pip value into your account currency! (in our example in USD)

Or use instead the other 2 formulas and then denominate these $ results with your account currency vs USD rate.

E.q 1:

1 pip = lot size x tick size / current rate
for Indirect rates as: USD/JPY, USD/CHF, USD/CAD)

For a trade of 10,000 USDCHF (0.1 lots):
USDCHF = 0.9290

1 pip = 10,000 (lot size) x 0.0001 (tick size) /
0.9290 (current rate) = $ 1.07

1 pip = lot size x tick size x base quote / current rate
( for Cross rates as GBP/JPY, EUR/JPY, AUD/JPY, EUR/GBP, GBP/CHF

a trade of 10,000 EURJPY (0.1 lots):
EURJPY = 121.35 and EURUSD = 1.3060

1 pip = 10,000 (lot size) x 0.01 (tick size) x
1.3060 (EUR/USD base quote) / 121.35 (current rate) =  1.07 $

Now, let's get back to our practice example:
Pip Value for 1.0 lot = $10
Pip Value for 0.1 lot = $1
Pip Value for 0.01 lot = $0.1

If the max Risk/trade = 2% = $200 and the pip value = $10

SL = $200/$10 = 20p / 1.0 lots
SL = $200/$1 = 200p / 0.1 lots
SL = $200/$0.1 = 2000p / 0.01 lots

So, in this example you can trade 1.10 lots.  The SL= 20p at this volume.

But if you want to use need a higher SL level for a trade, while keeping the same Money Management Rules, you can use smaller lot size ( mini-lots/micro-lots).

If you want to open 3 trades with 0.1 mini-lots/trade:
200p/3= 66p/trade (for each one of these 3x0.1 lots trades)

If you want to open 5 trades with 0.01 micro-lots/trade:
2000p/5= 400p/trade
(for each one of these 5x0.01 lots trades)

But what if you found a potential trade and you know the SL level ?
How many lots can you use for that trade ? ( this will be the only one opened trade, until is closed)

Lets say the SL = 90p needed for that trade.
This is how you can calculate the lot size according to your Money Management Rules:

Lot Size = Risk Amount* (in $) / Number of Pips x Pip Value
Lot size = (Capital x Risk%) / (Stop Loss in Pips x Pip Value)
*After each trade calculate the Risk Amount again or at least 1 time/week

Lot size = $200/90p x $10= $200 / $900 = 0.22 lots (for this trade example)
Lot size = ($10,000 x 0.02)/(90p x $10) =
$200 / $900 = 0.22 lots = 2.2 mini-lots = 22 micro-lots
(when Actual Account Balance is different, than Initial - we must calculate again the Risk Amount)

Best Regards,