Today we journey that little bit further down the Forex trading rabbit hole.
Everyone knows that money management is a core component of trading success, but very few understand what this means on a deep level. Indeed, most experts barely scratch the surface, with the extent of their contribution being “risk 1%-2% of your account on a trade”, as if this was a magic bullet to trading success.
But there is so much more.
A well-designed money management model gives you the ability to meet your trading objectives, unlike any other aspect of your Forex trading system.
To do this, you will be required to rewire your mindset.
The first step in this process is to rejig your understanding of two core topics:
Once you do this, you won’t ever look at the market the same way again.
Before we continue, we must give credit where credit is due. It’s upon the shoulders of giants that we stand and much of today’s topic can be attributed to the work of Dr Van Tharp, the world’s pre-eminent expert on position sizing (more commonly known as money management) and trading psychology.
This topic is complex. You might not understand it completely the first time. That is ok. The more you familiarise yourself with the concepts of trading success, the more they will sink in over time.
There is maths ahead, but stick with it. You need a basic understanding of probability to trade Forex, but this is about as complex as it will ever need to get.
What is expectancy?
Expectancy is how much on average you are likely to make or lose when you place a trade in terms of your risk/reward ratio.
For example, if you make on average $1.20 for every dollar you risk, then your expectancy would be 1.2 times your risk. If you make 80 cents for every dollar you risk, then your expectancy would be 0.8 times your risk. If you lose 40 cents for every dollar you risk then your expectancy would be -0.4.
An expectancy above 0 means you have a profitable trading strategy.
You calculate your expectancy by adding up your average risk/reward over a series of trades, but before we get to the equation it helps to understand what Dr Tharp calls R-multiples.
R-multiples: defining your initial risk
R-multiples are a way of defining the initial risk you take on a trade by thinking in terms of risk/reward.
If you place a currency trade with a stop-loss 50 pips away from the market, and you are risking $10 per pip, then your loss would be $500 if the trade went against you. This initial loss of $500 is your 1R risk. The R, of course, stands for risk.
You can then start to express your trades in terms of R, instead of in terms of dollar or pips.
For example, if you place a trade that risks $100 and you make $200, you have made 2R (two times your risk). If you lose the $100 you would have lost 1R.
If you talk to a trader who thinks in terms of R-multiples, they may say:
“I made 2.4R today”.
Or when they are assessing if they want to get into a position, they may think:
“I have the potential to make 3.6R on this trade”.
How to calculate the expectancy of your trading system
Now that you know what an R-multiple is, we can get back to calculating your expectancy.
Here is the formula:
(total R) / (number of trades) = expectancy
If you had placed 30 trades and earned 45R in the process, your equation would look like this:
45R /30 = 1.5
In this case your system has an expectancy of 1.5.
Money management rules can be developed independent of your entries and exits
Part of the value of this approach is that it separates your trading into two distinct components, each of which can be worked on independently.
The performance of your trading system as a whole will depend on the combined performance of each component minus any trading mistakes you make.
Let’s illustrate this relationship with a bag of marbles.
A bag of marbles
Recently I attended a 9-day trading course with the aforementioned Van Tharp. I have been following his work for 10 years (he started coaching professional traders in the 80s) so I jumped at the opportunity to attend his sessions here in Sydney.
Van Tharp’s belief is that:
“Position sizing is 90% of the reason for the variance in the performance of the professional traders”.
To illustrate this point and to underscore the importance of thinking in terms of “R” (among other reasons), we did a series of trade simulations using a bag of marbles.
While there are several different variations of the game, the basic premise remains the same:
Each pull from the marble bag is considered a trade and everyone gets exactly the same trades. Each simulation lasted at least 30 pulls from the marble bag (trades). There were up to 27 different participants in each game.
Ok, just to reiterate everyone had EXACTLY THE SAME TRADES.
The systems also tended to have a majority of losing trades, with some big winning trades on occasion.
So each pull from the marble bag is like a trade: i.e. your entry and exit.
The only control that each participant had was their position-sizing rules.
At the end of every game, every single person had different equity, no exceptions. The variation between individuals was massive, from bankrupt through to several million dollars profit.
After playing the game a few times it became very apparent how position sizing was not only critical to performance, but also how trading is composed of an entry and exit, and a separate position-sizing model applied on top.
A conversation with an ex-bank trader
Sean Lee is one of the true veterans of the Forex market. He began his career in the interbank market in the 1980s and has been consistently profitable as both a bank trader and in trading his personal account.
I was grabbing a coffee with Sean the other day, and he made a point that really hit home and helped tie some of my thinking about risk together.
When it comes to money management, you need to be prepared to accept risk.
Your returns are going to be in direct proportion to the amount you decide you are willing to risk.
When you understand the expectancy of a trading system and know the types of R-multiples it generates, the rest of the performance comes down to your choices with regards to your position sizing.
This is why some traders can turn 20K into 1 million, while other traders will be happy with 10–20% a year using a system with similar expectancy. It all comes down to the trader’s willingness to trade large sizes and accept risk, or their desire to avoid it.
This is not an advocacy program for trading large sizes, but it’s important that you become aware of how your choices around risk impact your position-sizing decisions and ultimately the size of your returns.
You can follow Sean over on Forextell.
Bringing it all together
While this topic is a little complex, it blends the statistical side of trading with personal preferences about risk to create a decision-making framework that ultimately protects you and helps you achieve your goals.
In this post you learned:
Do your best to digest this information one piece at a time. Start by defining your 1R risk for your trades and then move onto expectancy.
By taking small manageable steps to developing a cohesive money management model, you will be travelling a long way down the path of trading success.
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