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Forex Risk Management Basics

The wealth of forex traders depends on how they manage their money, and not on some kind of magical, mysterious grail system. Successful trading makes money. Successful trading with competent risk management can create tremendous wealth. Until you use the risk management technique, you will make some money here, lose a little there, but never win big. When it comes to risk management, it is amazing how few people want to hear about it or learn the right methods.

Inexperienced traders think that there is a magical approach to trading that correctly informs about market behavior and allows you to almost always make profitable trades. Nothing could be so far from the truth. Money is made at the expense of an advantage in trading, working with this advantage on a regular basis and combining it with a consistent approach to how much of your money you risk on each transaction. Today we will talk about the whole variety of money management tools that are known and used by traders around the world.

What is risk management

By launching an Internet search for these keywords, we got personal financial management services, how to manage other people's money, how to control risk, how to set stop loss, how to diversify your portfolio and the like.

In fact, risk management is none of the following:

  • it is not part of the system that dictates how much you lose in a given transaction;
  • it’s not how to exit a profitable trade;
  • it is not diversification;
  • it is not risk control;
  • it is not risk aversion;
  • it is not part of a system that maximizes performance;
  • it is not part of a system that says which trading tools to choose.

Risk management - This is part of the trading system, which says how many specific lots should be kept at the moment and how much risk should be taken. In other words, risk management is controlling the size of the bet. The most radical definition known to us was given by Ryan Jones: risk management is limited by how much from your account to risk in the next transaction. Please note that this definition does not apply to risk management by managing the size of an already open position, while Van Tharp allows it.

Today, there are many more or less correct definitions of money management, as well as the very methods of calculating the risk per transaction. In capital management, two categories are distinguished: proper money management and incorrect money management. Good governance takes into account two factors: risk and reward for it. Wrong considers each of the factors separately: either risk or reward. Proper capital management takes into account the full range of options available. Wrong - evaluates only certain properties or characteristics of the account, such as the percentage of profitable transactions or the profit / loss ratio.

The importance of risk management

Risk management is 90% of the game. Larry Williams turned $ 10,000 into $ 1.1 million in just one year. In his book, The Definitive Guide to Trading Futures, he says: "Money management is the most important chapter in this book." Indeed, many successful traders see money management as the most important tool that ensures complete success in the market. If money management is such an influential factor, it is important to know exactly what money management is from an objective point of view.

Probability and mathematical expectation

Beginners often do not understand the fundamental concept of probability. They have to deal with the horrors of a random process and invent various prejudices and myths about it, such as those when the broker paints them with the wrong candles or “dolls” hunt specifically for their feet.

The interesting book "Mathematical Illiteracy" by Allen Paulos can be a great introduction to probability issues. Paulos writes how an educated person said to him at a party at a party: “If the probability of rain on Saturday is 50 percent and on Sunday also 50 percent, then the probability of rain on the weekend is 100 percent.” Of course, this is complete absurdity for a more or less adequate person, although such cases also occur. As in that bearded anecdote about the probability of meeting a dinosaur - 50 to 50, or meeting, or not meeting. Anyone who knows so little about probability will definitely lose money in the stock market game. It is your duty to yourself to gain basic knowledge about the mathematical concepts associated with playing the stock exchange.

Ralph Vince begins his famous book Portfolio Management Formulas with the paragraph: “Flip a coin in the air. For a moment you will observe one of the most amazing natural paradoxes: a random process. While the coin is in the air, there is no way to say with certainty whether it will fall an eagle up or down. Although the outcome of a series of many throws could well be predicted. "

For players, the concept of mathematical expectation is important. It is called the player’s share (positive mathematical expectation) or institution’s share (negative mathematical expectation), depending on which side has more chances. If we are tossing a coin, then no one will have an advantage, our chances of winning will be 50 percent. But if you flip a coin in a casino holding 10 percent of each bet, then you will win only 90 cents for every dollar lost. The share of the institution makes your mathematical expectation negative. No money management system can stand against negative expectation indefinitely.

If you know how to count cards in a point, you may have an advantage over the casino if they don’t notice it and throw you out. Casinos adore drunk players and do not tolerate counting cards. An advantage will allow you to win more times over time than to lose. Good money management can help you make more profit from your benefits and reduce losses. Without an advantage, you had better give money to charity or spend it on beer. In trading, the advantage is given by the game system, which creates more profit than losses, price differences and commissions. No money management will save a bad trading system.

You can win only when you have a positive mathematical expectation, a reasonable trading system. A game of intuition leads to a loss of deposit. I am very interested in people who test their systems on the last three months of historical data, and then wonder why they lost a deposit. Many are not even surprised, but simply find a rational explanation from their point of view, such as the myth of the "doll", which we have already mentioned above. Of course, they are interested in the clinical sense - it’s very interesting what’s happening in their head. Many more novice traders behave like drunkards in casinos, switching from table to table, jumping from system to system, getting a couple of "moose" in a row. All this also comes from inadequate system testing and lack of knowledge of the basics.

The best game systems are tough and practical. They consist of a small number of elements. The more complex the system, the greater the number of its elements may not work. "Keep it simple stupid" is the main motto when developing a new system. Another important factor is the presence of a "stress test" of the system. The simplest is the optimization of system parameters. If most of the parameter sets yield a profit, then the system is good. The fact is that you cannot know for sure whether the market will behave the same way as in the past, in which your system showed good results.

That is why they look at all the results in aggregate - to check what will happen if the parameters of the system with respect to the future market become suboptimal. Another way is to eliminate the system’s strict settings as much as possible, make them floating, depending on some market values, for example, on volatility. These basic approaches are fully implemented in the MetaTrader terminal and allow you to find stable systems that are weakly susceptible to changes in the markets.

And finally, if you have developed a good system, do not indulge in it. Design another if you like variety. Robert Pricher puts it this way: "Most players take a good game system and break it down, trying to make it perfect." Now I would pay dearly for knowing this 5 years ago. If you already have a game system, then it's time to establish the rules of money management.

In my articles I often mention the influence of various factors on the final result of trading - spreads, swaps, the quality of quotes, and more. Most beginners think that these factors can be ignored. They consider themselves smarter than most of us. Brokers diligently support this fallacy, arguing that winners receive money from losers. They are trying to hide the fact that trading in financial markets has a negative mathematical expectation. Crazy amateurs take a frantic risk, providing commissions to brokers and profit to other traders. When they are washed out of the market, new ones come because hope never dies.

How much to risk

Most beginners die from one of two bullets: from ignorance or from emotions. Beginners play by intuition and enter into transactions that should never be concluded because of a negative mathematical expectation. Those who experience the stage of initial ignorance begin to build more acceptable game systems. When they become more confident, they stick their heads out of the trench, and a second bullet hits them. Confidence makes them greedy, they start to risk too much in one transaction, and a short series of failures kills their deposits.

If in each transaction you risk a quarter of your account, then your collapse is inevitable. You will be ruined by a short series of failures, which happens even with the best trading systems. Even if you risk only a tenth of your account in one transaction, then even last a little longer. A professional can afford to risk only a very small fraction of his funds in one transaction. The amateur has the same approach to trading as the alcoholic has to drink. He begins to have a good time, and ends with self-destruction.

Extensive research has shown that the maximum amount a player can risk in one transaction without compromising his long-term prospects is 2% of his deposit. We are not talking about overclocking, when a trader in one or two months tries to increase the deposit by thousands of percent, namely, long-term profitable trading.

Most lovers shake their heads when they are told about it. Many have small accounts and the 2% rule breaks the dream of big profits. Most successful professionals, by contrast, consider the 2% limit to be too high. They do not allow themselves to risk more than 1% or even 0.5% in one transaction.

The 2% rule reliably limits the damage that the market can do to your account. Even a sequence of five or six loss-making operations is not able to significantly worsen your prospects. In any case, if you play in order to have good statistics to attract investors, you are unlikely to want to show 6% or 8% of monthly losses. If you have reached this limit, stop playing until the end of the month. Use this rest time to re-evaluate yourself, your methods and the market.

Survival first

The first task of money management is to ensure survival. You need to avoid risk that can put you out of the game. The second goal is to ensure a steady stream of profit, and the third is to earn super-profit, but survival comes first. “Do not risk the whole state” - this is the first commandment of risk management. Losers break it by putting too much on one deal. They continue to play with the same or even greater position when it gives a loss. Most losers finally go broke when they try to recover from a blow. Good money management, first of all, will save you from a blow. Including from the heart.

If you have lost 10%, then you need to do 11% to recover, and if you have lost 20%, then you already need to earn 25% to get yours back. With a loss of 40% you need to make a brilliant 67%, and if you have lost 50%, then you need a profit of 100% just to return to the original level. When losses grow in arithmetic progression, the profits needed to recover them grow in geometric.

You need to know in advance how much you can lose, when and at what level you will limit your losses. To do this, you can take the maximum drawdown from your tests and multiply it by 1.5 - 2. If the real drawdown exceeds this value, it's time to stop. It is also important to determine how much you are willing to lose as a percentage of the deposit. For example, your system gives a drawdown of 20%, then you should stop trading when you reach 40% drawdown. But this is almost half the account and you would not want to risk more than 10% of it. In this case, you just need to reduce the risks in the system by 4 times, which, if a drawdown of 10% is achieved, will be equivalent to a test drawdown of 40%.

Get rich slowly

Traders working for a firm are usually more successful as a group than individual traders. They owe it to their superiors, who provide discipline. If a trader loses more than the limit value in one transaction, he is kicked out for disobedience. If he loses his monthly limit, then he is deprived of the right to play until the end of the month, and he becomes a boy who brings the rest of the coffee. If he loses his monthly limit several times in a row, the company dismisses or transfers it. This system makes corporate traders avoid losses. Individual traders act at their discretion.

A trader who opens an account of $ 20,000 and hopes to turn it into two million in two years, looks like a man who came to Moscow to become a successful showman. He may succeed, but exceptions only confirm the rule. Beginners want to get rich quick, but they ruin themselves when they are at high risk. They may succeed for a while, but a series of failures will find them sooner or later.

If you set modest goals and achieve them, you can go very far. If you can make 30 percent a year for a long time, people will beg you to accept their money under your leadership. If you manage at least 1 million, which is actually not a problem these days, then only your payout as manager will be 15-20 percent (namely, such a commission or even less should be put on long-term projects), that is, 45,000- 60,000 dollars a year, and this at the current rate of 200-300 thousand rubles a month is quite the average salary of the average Moscow leader. You will earn several million rubles in the market per year without taking a big risk and having 2-10 thousand dollars of personal funds in the account. When you plan your next deal, keep these numbers in mind.

Trade in order to get good statistics with constant profits and small losses, a smooth and stable yield curve and small drawdowns. Remember that in most high-income accounts, students pour in money, which saved on lunches and beer. Real money does not like high volatility and high risks.Put yourself in the end as a fat wallet investor. Where would you be more likely to invest in an account with a profit of 100% per month for a length of 3 months or an account with an average profit of 40% per year for a length of 10 years without a single loss-making year?

Sustainable Statistics

Indicators are the very first thing you should pay attention to when considering a particular system or method. How much money does the method create and over what period of time, what is the ratio between winning and losing deals compared to the percentage of winnings, what is the maximum loss the system made, and is it realistic.

There are several more indicators that you should pay attention to in individual cases. The reason why you should first pay attention to indicators, and then to logic, is because, for example, I developed and tested many logical methods that turned out to be ineffective. I built hundreds of trading systems according to the laws of logic, but all this did not have any success. Quite often, our subconscious ideas about what works and what doesn't work are wrong. You should never use an idea without proper testing in practice.

Some indicators should be paid more attention than others. Statistics from some areas may be more valuable than from others. Therefore, it is better to consider a range of data, rather than two or three indicators. Now let's get acquainted with the statistics that should be used to assess the quality of trading systems. They are not given in order of increasing importance, since they are difficult to rank without any connection with other data.

Expected value

The mathematical expectation of profit is the sum of the products of the probabilities of wins multiplied by the value of these wins, minus the sum of the products of the probabilities of losses multiplied by the amount of losses:

(Average winning trade) * (% of winning) (Average losing trade) * (% of losing)

It is believed that in order to consider the trading system profitable, the mathematical expectation must be positive. Moreover, if your system has a negative expectation, no risk management method will help you. Strictly speaking, this is not entirely true - each rule has its own exceptions. But we will talk about this when we discuss the Z - accounts and confidence intervals of the system. In a nutshell, for example, there are trading systems that always strive to have two losses in a row and two wins. If such a trading system is known, then it is possible to establish a money management approach that allows smaller positions after losing and larger ones after winning. The results of this approach can minimize losses and, indeed, even turn a loss-making system into a profitable one. But, I repeat, this is a special case and rather an exception to the general rule.

In general, there are a number of techniques that try to turn unprofitable systems into profitable ones, but we will not discuss them in this article. As for the very desire to force a profitably merging system to trade, then everything is quite simple. Any arbitrarily good system can have drawdowns. As a rule, many traders use several systems - when one suffers losses, the second earns and vice versa. In order to minimize these drawdowns or even get profit from all systems, traders are also looking for ways to manage money that allow doing this. Another fact that all traders are familiar with is the following: really good trading systems are hard to find. On the other hand, finding more or less suitable systems is no longer so difficult if you take this seriously.

There are many traders who have found the system, doing a full and comprehensive testing, and found that with its help you can earn, for example, 7% per year. Good money management can often make such a system quite suitable.

Recognizing the fact that good trading systems are hard to find, the effective use of money management techniques becomes necessary to improve the profitability of suitable systems as much as possible. Using solid money management principles allows traders to squeeze more out of the oldest systems, often with less risk. Traders can be sure that due to the ever-increasing power of a computer in the market, people will more quickly discover market features and use them in profitable trading systems. But finding a trading system is a small part of the problem. Account risk management is the main difference between regular traders and institutional traders, winners and losers.

The above formula does not take into account various costs, such as commission, slippage and others. When they are included in the above formula, a profitable system can become unprofitable - this must be remembered.

What matters is not how profitable your system was, but how clearly it can be said that the system will show at least minimal profit in the future. Therefore, the most important preparation that a trader can make is to make sure that the system will show a positive mathematical expectation in the future. In order to have a positive mathematical expectation in the future, it is very important not to limit the degrees of freedom of your system. This is achieved not only by eliminating or reducing the number of parameters to be optimized, but also by reducing as many system rules as possible.

Every parameter that you add, every rule that you make, every smallest change you make in the system reduces the number of degrees of freedom. Ideally, you need to build a fairly primitive and simple system that will constantly bring small profits in almost any market. And again, it is important that you understand - it does not matter how profitable the system is, while it is profitable. The money you make in trading will be made through effective money management.

A trading system is just a tool that gives you positive mathematical expectation so that you can use money management. Systems that work (show at least minimal profit) in only one or several markets, or have different rules or parameters for different markets, most likely will not work in real time for a long time. The problem of most technically oriented traders is that they spend too much time and effort on optimizing the various rules and values ​​of the parameters of the trading system. This gives completely opposite results. Instead of wasting energy and computer time to increase the profits of the trading system, direct energy to increase the level of reliability of obtaining minimal profit.

Obviously, if we put too little, we will not pay back the time spent, energy and beer we drink. It is much less obvious that if we bet too much on available capital, then sooner or later we will lose all our capital. Economic theories and common sense tell us that the higher the risk, the higher the expected return. This statement is incorrect: income is non-linear with risk.

Knowing that money management is just a numerical game that requires the use of positive expectations, a trader can stop searching for the “holy grail”. Instead, he can do a test of his trading method, find out if he gives positive expectations. The right methods of money management, applied to any, even very mediocre methods of conducting trade, will do the rest of the work themselves.

Total net profit

This indicator is calculated as gross profit minus gross loss. It will give you the broadest view of what a system or method can give you. Total net profit makes little sense if it is not broken down into years or by periods of time when it was received. Before making a final decision, you need to pay attention to other arguments.

Maximum drawdown

Here is the correct definition of the term: this is the distance between the maximum and minimum point reached after the size of capital has reached a new maximum. In other words, if at the moment the amount of capital is $ 5,000, but a few weeks ago it was at $ 6,000, then at the moment, the decrease in capital is $ 1,000. This recession will remain until the previous high of $ 6,000 is overcome. If the capital does not fall below 5,000, say up to $ 4,000 before the account reaches a new maximum, then it will be considered that the drop is $ 2,000. If the system previously recorded a maximum of $ 2,000, and then capital fell to $ 800 before rising higher, then the maximum decline will be $ 1,200.

The benefit from this indicator is not very large. First of all, the value of capital may fall another four or five times to a level close to $ 1,000, thereby proving the likelihood of more significant declines. Or if in another case the account could fall below $ 300, then this suggests that a drop of $ 1,000 was more likely an exception to the general rule. In addition, if a drop of $ 1000 was once recorded, this does not mean that in some magical way this level will not be overcome in the future. The fall of capital does not know that it should stop at any particular level. Losses do not realize that they should be $ 1,000 or $ 10,000. Nevertheless, such statistics help to understand what to expect when assessing the total risk by the method.

Stability coefficient

Trade stability can be measured as the ratio of profits to the maximum experienced drawdown during trading. Another common name for this indicator is the Recovery Factor.

If the result is less than 10 percent of net profit, then it is likely that it will be a very good system. But in general, if you think logically, it seems to me that such an indicator is not entirely correct. If the system was tested for 2 years with a net profit of $ 2,000, and the loss amounted to $ 1,000, then, following this logic, such a system should not be used. However, if the system was tested for 10 years and created a profit of $ 10,000 and the maximum drop in capital was $ 1,000, then the system is considered effective.

The problem here is that I can stretch as much time as I like, increasing profits to bring numbers in line with this criterion. The system will not get better from 10 years of testing. But what if a price drop occurs immediately after the start of your trade? What is the ratio then? If you have not earned any profit, then it is equal to infinity. The best ratio that you can use is the average drop in price to average annual profit, that is, in other words, to do tests for each year and calculate the ratio of profit for the year to landing, and then find the average value for all years. It will be more correct.

Average deal

An average transaction is simply the total net profit divided by the number of transactions concluded. Therefore, every time you make a deal, your result will correspond to the average result. It is best to use this indicator to measure the margin for error. If the system gives $ 10,000 for five years and 1000 transactions are needed for this, then the average trade is determined by $ 10.

This roughly corresponds to a profit of 10 points. You can go out to the store for half an hour to buy ice cream, and the market, meanwhile, will change by just 10 points. Subtract the spread, the influence of slippage, the cost of swaps, and you will have at best points 5. There is already a very small margin for error. Thus, the higher the average trade, the greater the margin for error. The best solution would not even consider a method or system that yields less than 10-15 points in an average transaction.

Average win / loss ratio and percentage of profitable trades

These two indicators individually are not very valuable. However, if combined, they can be beneficial. The essence of systemic trading is that it is a game of numbers. Like the average trade, a combination of these two indicators helps you calculate the margin for error. They can also say quite a bit about the logic of the method used.

In short, whenever the percentage of winning trades is 50 and the win / loss ratio is 1, the break-even point is reached. If the method yields 50%, then the average win / loss ratio should be greater than 1 (after deducting all expenses). The higher the percentage of winnings, the lower the gain / loss ratio can be for the trade to reach breakeven. The lower the percentage of winnings, the higher the gain / loss ratio must be for the trade to reach breakeven.

At 20% profitability, the gain / loss ratio should be 4 to 1 to ensure break-even. At 80%, the gain / loss ratio should be only 0.25. Moreover, the smaller the percentage of profitable transactions, the more sawtooth the growth schedule of the deposit, the longer the periods of drawdowns and the more difficult it is to psychologically follow the signals of such a system. Here is an example of this state of things:

In this case, the system has less than 40% of profitable transactions, while the ratio of average profit to average loss is 2: 1. The system makes money, but, as you can see, it’s like steps between which follow a protracted series of losing trades. With an increase in the profit-to-loss ratio, these “steps” become much more pronounced, and with a decrease in the number of profitable transactions, the distance between the ups also stretches. Many profitable traders using trend systems have just such a schedule. If you read the interviews with famous traders, especially with the so-called “turtles,” you will see that they often wait for a good trend for a whole year to recoup all the losses with one transaction and make a profit.

The graph above is just typical for this type of system, although it is "softer" than many other, more "hardcore" systems. Personally, I don’t really like this approach, although I have nothing against it. The reasons are very simple - trading is too complex from a psychological point of view and the schedule is unattractive for investors. Please note - for the first six months after the launch, the system just quietly drained. It will take nerves of steel, so as not to withdraw it from the account after several months of such trade. But such systems are very simple and reliable enough. It’s also quite simple to design such a system, but it’s difficult to trade on it. Many professionals consider the advantage that the system is difficult to trade - this means that you will have fewer competitors.

Let's look now at an example with a very high number of profitable trades:

As you can see, the percentage of profitable trades here reaches a record 83%. The ratio of profit to loss is slightly higher than 1 to 4. As you can see, the account earns. This is a good example of what you need to consider the ratio of profit to loss and the percentage of profitable transactions in the aggregate.

In fact, it’s not necessary to chase the notorious “gold standard” of the ratio of profit to loss of 5 to 1. Also, do not try to achieve 99% of profitable transactions. In my opinion, in everything you need to know the measure.My favorite ratio of these characteristics is about 1 to 1 with 60-70% of profitable trades, as in this chart:

Or like this:

Agree, this combination gives the most “pleasant” yield curve, and trading such a system is much easier psychologically. The minus may be the relative complexity of the search and development of such a vehicle.

Let's look at the following chart:

For a good system, the ratio of profit to loss should be at least 0.5 higher than the corresponding percentage of profitable trades minus 10%. That is, if our system has 70% of profitable trades, we will find the coefficient value for 60% in the chart above and get about 0.7. So, in order to consider our system very good, we need a coefficient of 1.2. In fact, finding such a system is very difficult, and if your parameters are close to those described above, this is a sign that your system is really good.

The ratio between the maximum win and the average win

This indicator also includes the ratio between the maximum loss and the average loss. The value of this indicator is small, but it can be used to calculate the potential of maximum gain. This is the biggest success that you really should not count on, but which, if it happens, will be a pleasant surprise. If the maximum winnings are three or four times higher than the average winnings, then you should not rely on the fact that you can get it.

If it is lower than the sum of three average wins, then you can expect that you will achieve even better results with this method. If the maximum loss is three or four times the average loss, then this probably means that some extraordinary event has occurred - a black swan or something like that. Losses of this magnitude should happen rather rarely. If the ratio is less than three, then higher losses can be expected.

Chance of Ruin

Probability of Ruin (POR) is the “statistical probability” that the trading system will bring the account to ruin before it reaches the dollar level, which is considered successful. Ruin is determined by the level of the account when traders stop trading. Knowing this value can be very important for traders. POR illustrates to traders the statistical possibility that their trading systems, as one would expect from probability theory, will move toward success or bankruptcy. To calculate the Probability of Ruin, traders must work hard on a terribly long equation. In short, the following are some basic input elements of the equation:

  • The larger the average wins, the lower the POR;
  • The higher the average risk of the transaction, the greater the POR;
  • The larger the original account size, the lower the POR;
  • The higher the percentage of winning trades, the less POR;
  • The smaller the score, the greater the POR.

POR is a value that should arouse the curiosity of all traders, but it usually carries little additional information, since most of the time its value is below 5%. However, in some circumstances, it can show traders that they are at great risk of ruining an account. When traders are faced with such a reality, this means that they are too risky for each individual transaction. Knowing this, traders should limit the risk of each transaction in order to try to reduce the POR to an appropriate level. Trading small portions of their account, traders, in fact, give themselves more chances to win.

Profit factor

The last, but no less important indicator that I would like to consider is the profit factor or profit factor (Profit Factor). This indicator is equal to the private of dividing gross profit by gross loss. If the gross amount of winning trades yielded $ 1,000, while the gross amount of losses turned out to be equal to $ 500, then the profit factor is 2. This indicator is confirming. This indicator is closely related to the ratio between the average gain / loss and the percentage of winnings. For example, at 50% profit with a gain / loss of 2.0, the profit factor is also 2.0.

Many other indicators can be generated and analyzed. However, at some point, further research becomes simply unnecessary and even harmful. It is best to choose a few indicators that talk about both risks and rewards, as well as some correlations between these two values. In addition to these indicators, you can use others. It does not matter how many indicators you looked at and how many of them satisfy your requirements, this will not change the results of the system. Using statistical indicators to estimate how much money you can earn using any particular system is not entirely true. Statistical indicators are used to evaluate when to use the system and when to abandon it.

Overview of Money Management Methods

I talked a lot about the characteristics of trading systems and identifying good or at least usable ones. In fact, finding a good system is not easy enough, but if you succeed, then it's time to talk about directly how to determine the volume of a transaction. I will not delve into each of the methods, at the moment I would like to introduce you to the main ones.

Newbie Method

The method prescribes to put on one trade all available capital with the maximum allowable leverage or so. Regardless of the result, close the account and leave either with a loss of 100% or with a large profit, as a rule, less than 100%, since newcomers tend to close their positions too early. Why is this strategy applied?

The logic is very simple. Beginners tend to get rich quick, and their deposits are small. Let's say there is a deposit of $ 100 and in each transaction we either lose everything or win 100% of the profit. Then for 10 successful transactions on the account will be about $ 100,000. The most important thing in this method is to understand that the strategy is played only once, because luck is exploited, not a statistical advantage, which, according to the law of large numbers, is realized as a result of a large sequence of wins and losses.

Lack of money management

This is essentially not a technique at all - a method that is most often used to test strategies. It consists in entering the market with one unit of the lot each time the system gives an entry signal. For example, always use lot 0.1.

Fixed fractional method

Using this technique, traders determine what percentage of the total value of the account can be risked for any given signal to trade. For example, a financial manager can choose a risk of up to 5%, but no more, from the entire account for each signal to trade. The fixed-fractional method has many different incarnations. Regardless of their names or interpretations, all of the following methods are a kind of Fixed-Fractional money management:

  • Trading at the rate of one lot for every "x" dollars of the account;
  • Risk in the amount of a certain amount of interest on the deposit in each transaction;
  • Optimal and safe f;
  • Kelly criterion;
  • The percentage of volatility.

Trading at the rate of one contract for each "x" dollars of the account

In this case, for each certain amount in the account, one minimum lot is taken. For example, you take 0.01 for every 100 $ lot. Then with a deposit of $ 735 you will risk 0.07 lots in each transaction. This method is good when the distribution of profits and losses on transactions does not deviate significantly from the average values. Simply put, when all, for example, losses on transactions are approximately similar to the average loss. If you have a maximum loss of four or more times the average, this approach is not very suitable.

The fact is that this approach does not take into account the amount of stop loss, and if they vary from transaction to transaction several times, the curve of the deposit growth will be rather uneven and often large profits or large losses will appear. The advantage is smaller drawdowns in the account compared to risk methods with a fixed percentage of the deposit and a smoother capital increase.

Risk in the amount of a certain percentage of the deposit in each transaction

This method is the most common and familiar to almost all traders. The bottom line is that you risk in each transaction, for example, 1% of your account and nothing more. Knowing the size of the stop and the amount on the deposit, you can easily calculate the lot:

Lot =% Risk * Capital / SL in points

For example, you have the same $ 735 in your account. You are about to make a deal on EURUSD with a stop of 30 points and a risk of 1%. Then you risk $ 7.35 and 7.35 / 300 = 0.0245 or 0.02 lots. The plus here is that capital gains have a more pronounced geometric progression. The downside may be large drawdowns. All tools for calculating the lot in this way you can find here.

Optimal f

This is a formula that has become popular thanks to Ralph Vince. F denotes a fraction or fraction. This is the optimal fixed share for trading in any scenario. This percentage represents the optimal stake in this particular situation. However, the optimal fraction (stake) established for one transaction will not necessarily be optimal for another. Many people are well aware of this approach, but it is fraught with some dangers in relation to which one must be vigilant.

For example, it follows from the optimal f formula (which I will not give in the framework of the article) that the maximum drawdown when using the optimal f will be at least fopt% of the account. In other words, if fopt is, for example, 0.5, then we will have a drawdown of at least 50%. Ralph Vince argues that "if you do not trade for optimal profit, then you have a place in a psychiatric hospital, not in the market." It does not take into account the fact that, having received a 99% drawdown in trading “for the sake of optimal profit”, we still risk taking a seat if not in a psychiatric hospital, then, after reporting to our wife or investors, in a trauma clinic, and not waiting for maximum growth capital. In addition, the distribution of the outcome of transactions greatly affects the value of fopt. So, fopt for two strategies that bring the same profit and have the same maximum loss can vary very significantly.

The Achilles heel of the optimal f method is that, it is completely based on the historical results of the system, namely, on maximum loss. The level of risk accepted when using fopt implies that we will never get more loss. But who can guarantee this? There is no reason to assume that the maximum loss and maximum drawdown achieved will remain so in the future. One way or another, in any case, the optimal F has many problems and solutions. If you are interested in options for risk management methods and optimal f in particular, write comments and we will discuss them in future articles.

Safe f

This is simply a safer regime of the optimal fraction, one of the attempts to solve one of the problems of optimal f. Despite the name, safe f is still never safe. Leo Zamansky and David Stendahl tried to overcome large drawdowns by imposing an additional restriction on the maximum allowable drawdown. Partly they did it, but the method is still very risky.

Optimal f considering volatility

Murray Ruggiero proposed adapting the position size calculated using the optimal f to the current market volatility. The idea is based on the hypothesis that with low market volatility, the chances of a large loss are lower than with high volatility. In fact, the problem of a huge drawdown in this approach has not gone away, just the risks have slightly decreased.

Volatility percentage

Volatility is a measure of price volatility over a given period of time. It can be described in various ways, among which the most often used average true range - ATR. In fact, the method is very similar to the fixed percentage of capital method. Here, a fixed percentage of capital is also taken, but instead of substituting the real stop loss into the formula, we will calculate the stop loss by ATR, without the multiplier, among other things.

This value will only be used to calculate the lot size. The higher the market volatility, the more nervous it is, the lower the lottery. If you already use stops calculated according to ATR, and you consider the lot size based on a percentage of capital, then you are using this method exactly (although you probably did not know this).

Drawdown management

This method is also somewhat similar to the fixed percentage method. But here we have the opportunity to set the maximum drawdown acceptable for us. The lot is found by the formula:

% Risk * (Capital - (1 - Max _% _ Dropdown) * Maximum_capital) / SL

If we set the maximum drawdown of 30%, our current deposit is $ 1000, and the maximum was $ 1230, while we risk 5% of our drawdown in each transaction, and the stop loss is 20 points, then:

0.05 * (1000- (1-0.3) * 1230) / 200 = 0.0348 or 0.03 lots.

If lots could be crushed indefinitely, then according to this formula, we would guaranteed never reach a drawdown of 30%. But since the minimum lot is finite, in the end (in the case of an infinitely long series of failures) we will go to lot 0.01. Then, as you exit the drawdown, the lot will increase up to:

0,05*(1230-(1-0,3)*1230)/200 = 0,09.

Then, only after overcoming the previous peak of profitability, the lot will be increased. A big plus of this formula is that the risk is automatically adjusted based on preferences for maximum drawdown. The downside is that at the very beginning of trading we start working with too much risk (5%), and to use the risk, say, 1%, we need a rather large deposit (we are limited by the minimum allowable lot).

Another option for this method is to use the maximum historical drawdown in points instead of the SL value in the fixed percentage formula:

Lot =% Risk * Capital / Max Drawdown in points

This method also takes into account drawdown, while, unfortunately, it seeks to underestimate too much.

Kelly method

The method determines the optimal percentage of risk that should be used to maximize the "utility" function, presented as the logarithm of capital. Kelly's method we have already examined in detail here. The method is mainly used to disperse the deposit and you need to be extremely careful with it.

Fixed ratio

The common problem of all methods that use a fixed share of capital is that various methods either solve the problem of maximizing capital growth regardless of risk (for example, optimal f), or minimizing risk (for example, risking no more than X% of capital). Trying to resolve this contradiction, Ryan Jones concludes that the ratio of the traded number of lots to the capital increment required to increase the number of lots per unit (or the minimum increment in the number of lots) should be constant.

In fact, this is a pretty fun method that Ryan Jones promoted, and there are some interesting stories involved. This is a topic for a separate article, but their whole point boils down to the fact that the method turned out to be no better than other methods of money management, with its own shortcomings.

Larry Williams Method

In setting the record, Larry Williams used the Kelly formula as the initial risk using the margin value on the futures contract. The dynamics of capital was also instructive: first, capital increased from $ 10,000 to $ 2,100,000, then dropped to $ 700,000 (drawdown 67%), and ended the year at around $ 1,100,000.By the way, at that time Ralph Vince worked for him as a programmer.

The game of "market money"

As experience shows, it is much more important for an investor not to lose a small part of their initial capital than a significant part of the profit received. The meaning of the method is to take less risk on the initial capital, but more aggressively risk the profit.


All of the above methods determine the initial risk when opening a position. The current or effective risk of an open position, generally speaking, is not equal to the initial risk. As long as the transaction does not have unrealized (paper) profit, the effective risk is positive. A transaction protected by a stop order at a breakeven level has zero effective risk.

As soon as the stop moves beyond the breakeven level, the effective risk becomes negative. This means that the position has a guaranteed profit, locked by a stop. At the same time, capital is no longer exposed to risk, so we can risk guaranteed profit, respectively increasing the size of the position.


Averaging is such a work strategy when you either made a mistake or simply made any transaction (the first one that occurred to you) and the price went against you, and you perform the same operation at a more favorable price. The main disadvantage of averaging is the fact that you do not know in advance what price the market will go against you. But if you have a lot of money - you can afford the movement of 500, 1000 or more points.

Although such shifts in the market happen infrequently, it is still not the best strategy, especially if you see that you made a mistake in determining the direction of the trend. Nevertheless, if averaging is applied with stop loss, the risks are calculated, the number of averaging is strictly determined, then, if it is justified, it is quite possible to use such a method for managing funds.

Matching winnings and losses when trading

Using this technique, traders determine the volume of trade after successful wins or losses. For example, after a lost trade, they may decide to double the volume of trade after the next signal to trade in order to recover losses. A simple example of such a system might be the Martingale method. The Martingale system has one catastrophic drawback: when losing, bets increase, and only the size of the initial bet will win.

As a result, bets are growing exponentially, and winnings tend to zero. After the first loss in the system of games with equal chances, the player falls into the position of always winning back. In general, to build a more or less adequate money management system, which even under certain conditions can really make a profitable system out of a loss-making system, it is closely connected with the concept of a z-account. As part of this particular article, we will not delve into this topic either.

Trading according to the balance chart

Among the methods of money management, this method is often found, although few take advantage of the advantages that it is able to give. Strictly speaking, there is only the following option: we build a moving average on the profit chart, trade when the profit is above the moving average, trade “on paper”, that is, virtually when the balance chart is under the moving average.

At the same time, for some reason no one dares to build a full-fledged trend system according to such a schedule, but you can use the intersection of two moving averages or even combine this approach - enter the “profitable trend” on pullbacks on oscillators using the same moving averages or channel indicators for identification of this very trend. This will give us the opportunity to avoid drawdowns, trading during them virtually, "on paper", and enter real transactions only when the system feels good.

Safety curve

This method also combines the average win / loss ratio and the percentage of profitable trades that we discussed above. The fact is that this ratio varies nonlinearly in time, it is not a constant value.

On the zero return curve (KND), the system works at zero, below it - at minus. Within the limits between the CPV and the safety curve (KB), the system will work with interruptions, drawdowns, but still make a profit. Above the KB is the zone of sustainable profit. The idea here is that as soon as the characteristics of the TS go below KB, it’s worth switching to a reduced lot or to “trading on paper” altogether. Thus, we can wait out unprofitable periods and trade in the system only when it shows the best results. This means that during periods of drawdowns we will not make real transactions, which will significantly improve our final statistics.


The methods of managing funds presented above are basic methods on the basis of which other, more specific and complex strategies for managing money can be developed. Remember that money management is primarily a game with numbers, so you should not use new methods of risk management without proper testing. Sometimes the money management system, which has proved to be good for one system, shows opposite results in relation to another.

Nevertheless, it is worthwhile to pay as much attention as possible to money management issues, because no matter what different approaches to trading the famous and successful traders have, they all agree on one thing: a competent approach to money management is 90% success. This article turned out to be very long, but it contains only information about the whole variety of money management tools that are known and used by all traders around the world. If you would like to get acquainted with the world of money management in more detail, write comments, and I will try to describe in detail the above methods in subsequent articles.

Watch the video: Forex Trading For Beginners - Risk Management (November 2019).

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