Lesson 8 - Money Management (MM)

Statistics show that 80% of newcomers to trading on Forex lose their first deposit. In a lot of cases, it happens because a trader does not know anything about Money Management (MM), does not know how to use MM, or does not think MM is necessary.

Using MM is vital to a successful strategy. Ignoring MM rules is the biggest mistake of newcomers and even of experienced traders. Why does this happen? A lot of traders are trying to make thousands of dollars from just 100 USD. Unfortunately, this does not happen in Forex trading. If you have such illusions, it is better to go to a casino—at least the environment is friendlier there. Forex trading is not a game, it is a serious job. If you wish to learn Forex trading and want to trade for a long time, I suggest you follow my lessons and do the exercises that follow each lesson. This is essential to understanding how MM works and how to benefit from MM.

MM has two main functions: limiting the risks and increasing our capital. We can use MM to limit our risks by saving our deposit if a price development goes against us. And when our trades are profitable, there are MM strategies that can help us increase our capital.

Below are the basic rules of MM:

1) Never risk more than 1–3% of your deposit in one trade.

This is one of the most important rules. What does this mean? For example, risking 2% in one trade means that you will never lose more than 2% of your whole deposit in case the price develops against you and your Stop-Loss will be triggered. If your Stop-Loss size is 2%, you will not lose more than 2% of your deposit. And it means that even if ten trades in a row end with losses, you will lose only 20% of your deposit.

Some books recommend to not risk 10% of your deposit in one trade. Never do this. Imagine, only five unsuccessful trades in a row will cost you half your deposit! And experiencing five unprofitable trades in a row is common—and more common is ten.

How do you calculate and determine the lot size on your own, so that you manage your money successfully? I have included detailed instructions below.

2) The risk (Stop-Loss) / reward (Take-Profit) ratio of each trade should be 1:3 or 1:2.

Or, at least, 1:1. If the ratio is lower—for example, a Stop-Loss is 30 pips and Take-Profit 5 pips—this is not going to be a successful long-term strategy. If you get several stops in a row, how many profitable transactions do you need to cover all the losses? Of course, there are strategies or trading systems (for example, “scalping”) where the Stop-Loss is bigger than or equal to the Take-Profit order. However, in these cases, such systems must be tested on historical data, and the statistical profitability must be obvious. Let’s say our Stop-Loss is 20 pips and Take-Profit 60 pips. We can experience several losses and still be profitable long term.

The ideal situation is when a Stop-Loss is 5–10 times smaller than the profit that we forecast. However, this is very rare, and you’ll need to wait for a long time. Unfortunately, another newcomer mistake is impatience because they feel an enormous desire to trade. Indeed, you must learn to wait, to be patient. You will learn this over time, but it is a trading mentality that we are going to review in another lesson.

In the following, we will learn how to determine the right lot size and never exceed 1–3% risk!

How to calculate a lot size

First, we must decide how much of our deposit we are willing to risk in one trade. For a newcomer, 1% is optimal. Let’s say your deposit is 1,000 USD. This means that we can lose no more than 10 USD (1,000 X 1% = 10 USD) in one trade.

Now we will determine the size of our Stop-Loss order in pips. Let’s say there is an excellent opportunity to buy EUR/USD, and according to our trading strategy the Stop-Loss should be placed 25 pips below the price. It means that our risk is 25 pips, which equals 10 USD.

Accordingly, our trade one-pip price is going to be 0.4 cents (10 / 25 = 0.4).

We now know that 1 pip costs 0,4 cents (10$/25 pips=0.4).

By default, each currency pair’s price per 1 pip is calculated for 100.000 units (or 1 lot). Therefore, 1 pip for EUR/USD is 10 USD.

So, following the lot-size formula, we just divide our trade’s price per 1 pip (0.4) by the currency pair’s price per 1 pip (10 USD).

Therefore, 0,4 / 10 USD = 0,04. The answer is that our lot size is going to be 0,04.

Lot-size formula

Lot size = D% / SL pip / Price

D% = “deposit” x “risk % in one trade” (example: $1,000 x 2%=$20)

SL pip = Stop-Loss size in pips (for example, 30 pips)

Price = The pip price of the traded currency pairs market price for 100,000 units (1 lot). Each currency pair has a specific, default pip price. For example, EUR/USD, GBP/USD, AUD/USD, NZD/USD 1 point out of 1 lot volume is equal to $10. For other currency pairs— for instance USD/JPY and USD/CHF—thepip size is fluctuating depending on the exchange rate for that day (for example: 0.0001 x 100,000 / 0.9495 (USD/CHF exchange rate) = $10.5).

Exercises

 

1. Let’s say your deposit is 2,500 USD. You have decided to buy EUR/USD. You would like to place a Stop-Loss order at 35 pipsand risk 2%of your deposit. What is going to be the lot size?

2. Let’s say your deposit is 15,470 USD. Your trade system sent you two signals: (1) sell GBP/USDwith 60 pipsStop-Loss and 150 pips Take-Profit order, and (2) buy EUR/USD with 40 pips Stop-Loss and 130 pips Take-Profit order.

• What is the lot size of each trade if the risk is 3%?
• What is the profit in USD going to be if both Take-Profit orders will be executed?

I wish you success!

Do you have any questions? Please write your questions in the comments section—we will do our best to solve them with you!