Money management – the key to success

money management

Money management is the key to success. It doesn’t matter how many pips you win, all that matters is how this reflects in equity curve. Before we start talking about money management styles let’s answer a simple question, shall we? You have a starting balance of $10,000 and you lose 10%. What is the necessary amount to restore the original equity value of $10,000? No, it’s not 10%! It’s more. You lose 10% which is $1000 and you are left with $9,000. The necessary amount to restore the original value = 100*(10000 – 9000)/9000 = 11%. If you lose 20% of your original equity you need 100*(10000 – 8000)/8000 = 25%  just to reach breakeven! If you lose 50% of your original balance you need 100% to reach the original value. Money management tries to prevent such unpleasant surprises and turn the surprise into a statistical fact that can be computed.

Amount of equity lost Amount of return necessary to go back to breakeven
10% 11%
20% 25%
25% 33%
50% 100%
75% 400%
90% 1,000%

You see how hard it is to recover from a series of losses. But with proper money management it can be done.

First, a little background. If you already know these things you may skip this step.

What is a value of a pip?
For example my traded pair is EURUSD. The current price is 1.32589. So, the value per pip is 1 pip / 1.32589 = 0.00001 / 1.32589 = 0.000007542 EUR.
The base currency is EUR, if you want to know the value of a pip in USD, use this formula: pip value x exchange rate = pip value in USD

What is a lot?
When you open a trade, you are not trading pips or values, you are trading lots. There are standard lots (100,000 units) and mini lots (10,000 units).
So, if you trade one lot, the value of your trade per pips is pip value x lot units = 0.000007542 * 100000 = 7.5 EUR / lot when the market moves one pip.

What is leverage?
Leverage allows you to trade more units 20,30,50,100,200,400 for every unit you have. Consider this as a loan from your broker. If the leverage is 100:1 then for every dollar you put in the market, your broker puts another 99. The value of a lot is not affected by leverage, it remains the same.

Ok, now let’s dive into real money management staff.

Suppose you you have an EA or  a system with the following characteristics:

Profitability: 40%
Stop loss: 100 pips
Take profit: 4o pips
Maximum historical DD: 1,000 pips
Consecutive losing trades: 8

Suppose that overall is a good EA because it obeys all long term, profitability rules, it recovers quickly form a drawdown period, the drawdown length is short, Annual Average profit / Maximum historical DD is let’s say 1.5.

Question: For a starting balance of $10,000, standard lots, how many lots I’m going to risk per trade?

Answer: We should expect to lose 1,000 pips, this is maximum historical drawdown, bu market conditions may change anytime that’s why is always a good idea to start a Monte Carlo analysis and find out the maximum drawdown that has to be supported before trashing the strategy. Let’s say that MC analysis shows a MCWCS of 1,800 pips.

I don’t want to lose more than 20% of my initial equity, so how many lots should I trade? As I stated before, I’m willing to lose $2,000. If the consecutive number of losing trades is 8 (-100 * 8 = -800 pips) then the worst case scenario (WCS) shows 18 losing trades ( -100 * 18 = -1,800, SL=100). If 1,8000 pips should not exceed $2,000 then lotsize pe trade should not exceed 2000/1800 = 1.1 amount of currency.
On Alpari UK, minimum allowed lotsize is 0.1 and minimum lot increments value is 0.1. So, I will use 0.1 per every trade, no more, if I want to keep my money safe.
1 lot = 10 USD. -> 0.1 lots = 1 USD. The lotsize should not exceed 1.1 amount of currency so it’s perfect for me to risk 0.1 lots per trade.

The EA is good, the equity curve is great but if you trade it using higher risk, more than 0.1 lots per trade you will loose your account and it would be your fault. A good forex robot can easily blow an account if proper money management is not used. I have just showed you how to calculate the lotsize properly taking the following elements into consideration:

Profitability
Stop loss
Maximum historical DD: 1,000 pips
Consecutive losing trades: 8
Worse Case Scenario calculated using MC analysis
Maximum drawdown you are willing to accept in case of Worst Case Scenario

I really hope this article is useful to you. If it is, please help me spread the word and share 🙂