FOREX CASH DETECTIVE MONEY MANAGEMENT: THE TWO GOLDEN RULES All rights reserved. Except for brief quotations in a review of this publication, no part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means including electronic, mechanical, photocopy, recording, scanning or otherwise - without the prior written permission of the author. Risk Disclosure Statement. Trading any financial market involves risk. This e-book, software, and the website and its contents are neither a solicitation nor an offer to Buy/Sell any financial market. The contents of this e-book and software are for general informational purposes only (contents also mean the website and any email correspondence or newsletters related to the website). Although every attempt has been made to assure accuracy, we do not give any expressed or implied warranty as to its accuracy. We do not accept any liability for error or omission. 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For example the ability to withstand losses or to adhere to a particular trading program in spite of the trading losses are material points, which can also adversely affect trading results. There are numerous other factors related to the market in general or to the implementation of any specific trading program, which cannot be fully accounted for in the preparation of hypothetical performance results. All of which can adversely affect actual trading results. We reserve the right to change these terms and conditions without notice. You can check for updates to this disclaimer at any time without notification. The content of the website and this ebook and software are copyrighted and may not be copied or reproduced. MONEY MANAGEMENT IN A NUTSHELL The first question that needs to be answered is - what is money management? We touched on this in the introduction. But, as it applies to Forex, what is it really? The short answer is that money management is simply a set of rules to manage the risk involved in trading. There’s more to it than that though. Money management, when applied properly, is the simplest way to keep your emotions out of the trade and to maximize your profits while keeping your risk levels within your own comfort zone. Notice that I said “within your own comfort zone”, and not just at a consistent level. The next thing that needs to be considered is why you need money management. After-all, any trade has a 50/50 chance of being a winner, right? From that, it stands to reason that simply limiting your losses is all that is required to stay ahead in Forex. The problem is that it simply doesn’t work that way. Yes, any given trade has a 50% chance of being a winner. But let’s look closer at this idea. I actually know a trader who doesn’t use a trading system at all (or at least not what most of us would call a system). He simply looks at a currency and if it is currently rising he buys, if it’s currently falling he sells. The funny thing is that he is consistently profitable. When new traders look at what this particular gentleman does, they assume that his secret is simply playing the odds. When you look closer he really only wins about 30% of his trades, and the only thing that keeps him profitable is a very well defined money management system. Getting back to it, imagine for a moment. You’ve made a trade. It doesn’t matter what trade or how much at this point, you just made a Forex trade. With that trade you have a 50% chance of winning or losing, right? The answer is of course yes, every trade can only have two possible outcomes. You will either make money or lose money on that trade (you could always break- even, but if you’re exiting trades at the breakeven point why trade in the first place). With that in mind you enter a trade and your first trade is a winner. When the next trading opportunity arises, again you enter with the idea that you have a 50% chance of making money, and again the trade is a winner. In fact it’s quite possible that you could have 10 winning trades in a row. It’s just as likely that you could have 20 losing trades in a row. The problem with the 50/50 idea is that each trade is independent of the other. Every trade does have a 50% chance of earning you money, but if you look at groups of trades it isn’t uncommon to see large streaks of winners or large streaks of losers. If you looked at the millions of trades that take place each day you would very likely see groups where there were hundreds of winners or losers in a row. The question then becomes how do you compensate for the times when you hit four or five losing trades in a row? The answer is money management. If you have a money management system in place you have a method to capitalize on the winning trades to ensure that you make the most from your earnings, and you have a method to minimize your losses when you are on a losing streak. THE ELEMENTS OF MONEY MANAGEMENT Even if your trading system only produces a 30% win rate – when you look at a group of 100 trades 30 of them earned you money and 70 lost – if you use sound money management you can stay quite profitable and continue to grow your trading float. For now, let’s just consider what a sound money management system includes, and the factors you need to understand to. Your Money Management System Includes: 1. %R – Percentage Risk – The Maximum amount you are willing to risk on any one trade. 2. Stop Losses – A clearly defined stop level that fits with your %R to ensure you never lose more than your maximum risk level on a trade. 3. Trailing Stops or Take Profits – A system that defines when (and how) you will exit a profitable trade. Some traders use take-profit levels, in this book we will take briefly about TP, but we have devoted an entire chapter to trailing stops. 4. Trade Size – Using your %R, and your stop loss, your money management system defines how much you will trade when you enter any given trade. Stated like that, in four simple steps, money management sounds simple enough. However there’s more to it. You will need a clear understanding of what your trading float is and how it affects trade size. You will require a clear understanding of leverage and how it affects risk. You will also need to understand how trading systems (especially those that include ideas like averaging down) can erase your trading account in a very short period of time. Finally you need to understand the importance of back testing, with your money management system, to ensure you can make money before you ever put your own money on the line. By the time we are finished here you will have that knowledge and more. In the next chapter we will start by simply talking about trading floats, and how leverage works. If you’re an experienced trader this may seem like basic information, but it is important to have a clear understanding before you create your money management system. TRADING FLOAT AND LEVERAGE Before we begin managing anything we have to start with something to manage. The money you hold in your trading account is called your trading float, and really it is the most important part of your money management system (obviously without capital to trade with you won’t be trading anything). Since most of us can’t afford to put $100,000 on the line when we start trading we also need to talk about leverage. This information is targeted at newer traders, but even the experienced traders who read this book should take the time to review this chapter. TRADING FLOAT We all need to start somewhere on our road to Forex profits, for most it simply starts with the trading float. That is, the amount of money we actually put in a live Forex account to trade with. It’s actually one of the most commonly asked questions amongst newer traders: How much should I trade with to start out? The answer to that question obviously depends on a number of factors. How much money you can realistically afford to lose for example. I want to start with two rules for those who are starting out. First it’s important to think of your trading float in terms of capital. If you are trading for a living, or even trading part time, the money you put into your account to is like capital into a new business. When starting a business, the capital you put in when you start out defines how much you can do to grow that business. It will dictate how much you can spend on inventory, how much you have for advertising, and how much you can afford to pay employees to take on portions of the work. By the same token, the amount you put into your Forex account when you start, will determine how much you can trade, what trading systems work best for your account size, and ultimately it can affect your potential for profit in the long run. From that it’s important to have an understanding of what to start with, but more importantly when. To look at the question closer, let’s make two rules. RULE #1 – NEVER TRADE WITH MONEY YOU CAN’T AFFORD TO LOSE The first rule is simply that you shouldn’t trade with money that you can’t afford to lose. Too often you hear of traders who lost their assets because they made the excellent decision (and yes I’m being sarcastic) to mortgage their house to start a trading account. Even if you have a sure-fire trading system, and you KNOW you’re going to earn huge profits, trading money that you can’t afford to lose is the #1 way to lose your entire account. The reasons for this may actually be different than you think. To demonstrate the importance of this one rule let’s talk about two new traders. Trader #1 Bob - We have Bob who has started with $10,000 that he saved and set aside specifically for the purpose of starting to trade part time. He realizes that if he started with more his profit potential would be greater, but being somewhat reserved Bob wants to get his feet wet (so to speak) before making any rash decisions. Trader #2 John - On the other end of the spectrum John who took out a second mortgage, ran up his Visa to $20,000 and quit his day job to trade Forex. With the mortage and the credit card debt, John managed to start his account with a respectable $200,000. An experienced trader told him that the more he could start with the more he would make. John took this advice to heart and made sure he started with as much money as he could afford. John’s idea is that, if he devotes himself entirely to his new trade, there is no way he can lose. At first glance, most might say that John has a greater chance of immediate (and bigger) profits. In some ways there is truth to that statement, but unfortunately it rarely works that way and there is one big reason why. Look at our two traders from an emotional perspective. In the case of Bob, he has taken the time to save the money he needed to start. $10,000 is likely a large amount of money to Bob, but he set aside for the purpose of trading and that is what he is going to do with it. He still has his day-job, and he has no immediate pressures to profit from Forex. Bob has entered the world of trading as someone who is looking to learn how to earn money. And, more importantly, if he did end up losing his entire account it wouldn’t affect his home, his family, or his lifestyle. In other words, Bob can take his time to learn what he needs to, he can afford to make a few mistakes along the way, and he isn’t dependant on his Forex profits. John, on the other hand, suddenly has a second mortgage payment, a credit card debt to service, and he is completely dependent on earning a profit. Even with that trading system, that he used on the practice account to double the account in three months, John is almost destined to fail. With his entire life hinging on trading profits, it will be near impossible for John to keep his emotions out of the mix. He will experience large losses, big draw-downs, and in the long run will likely lose everything. Notice that I said he “will” experience large losses, and not might. Emotional trading is the quickest way to ensure failure at Forex. The emotional trader will try to take revenge on the market when he/she loses, they are more likely to make bad trading decisions, and they will have more trouble following any type of trading system. If you want to know the simplest way to ensure you trade with your emotions, it’s to put your entire lifestyle on the line. Really it’s about giving yourself the time to learn your new trade. The more time you have to invest in learning, the more success you will have. By jumping in with everything on the line there is immediate pressure to win, and you don’t have the time to experience the mistakes that most new traders will make. RULE #2 – NEVER TRADE WITH A FLOAT THAT’S TOO SMALL The next rule about deciding on a trading float is simply that you shouldn’t start a live account without enough money to decently manage that account. Just because your broker says you can start a mini-account with a $200 deposit, and trade with a 500:1 leverage, doesn’t mean that you should. With too little money you will be limited in the trading systems that you can use, and you won’t be able to follow a decent money management system. Again it’s about allowing yourself time to learn and grow. With too small of an amount to start out, your first few mistakes you make will erase your account and you’ll be more likely to give up before you ever learn how to truly earn in the Forex markets. There are really no hard-and-fast rules here. For a mini account with 200:1 leverage, $10,000 would be a decent minimum to start. For a real Forex account, I wouldn’t start with anything less than $50,000. Keep in mind that those are the smallest amounts that I would use. If you can afford to start out with more, you should! Let’s discuss leverage for a moment to gain a better understanding in this area. BRINGING LEVERAGE INTO THE PICTURE Almost all Forex traders employ leveraging when they trade. Unless you’re a big bank or a big business, with millions to put on the line, leverage is simply a fact of trading. Most new traders won’t have millions they can afford to lose. So, they employ leveraging to allow them to trade at all. To clarify what leverage is let’s just talk about a trade with one lot in the Forex market. We know that one lot of currency is worth $100,000. To trade that lot at 1:1 (with no) leverage you would need to put $100,000 on the line until you closed the trade. On the other hand, if you were trading with a 100:1 leverage, it means that your Forex broker will trade that $100,000 of currency if you only put 1% of the money on the line. In other words, with $1,000 you now have the power to trade that same $100,000 lot. Let’s assume our 1 lot trade was a winning trade, and we earned 100 pips by the time we closed that trade. To keep things simple we will say that 1 pip is worth $10. On the 1:1 trade we made $1000. On the 100:1 trade we also made $1000. The difference in this case is the amount of money we had to invest to earn that money. $1000 is 0.01 (or 1%) of $100,000. From an investment standpoint we could have earned more money with a low-interest savings account. With the leveraged trade though, $1000 is 100% of $1000. In that case we are actually earning some money. Leverage allows us to earn more money while only investing a smaller amount. It’s simple right? The power of leveraging is what makes Forex attractive to so many people. With a small amount to start out they are able to trade large amounts of currency and profit as though they had the full amount on the line. The problem is that, along with huge profits, leveraging can also equate to huge losses. If the 1 lot trade we used in the example had been a losing trade (and we lost the same 100 pips) we would have erased our $1,000 in just one trade. It’s very important to keep potential losses in mind when chosing a broker and the leverage that they allow for. There are now Forex brokers offering 400:1 or even 500:1 leverage. This does allow for traders to move huge amount of currencies with very little money invested, but it also greatly increases the risk involved. The biggest problem with huge leverages is that it often attracts newer traders with smaller amounts of money to start out. Just because you can start an account with $5,000 and use 500:1 leverage to trade full lots with only $200 invested for each lot doesn’t mean that it’s a good idea. In the long run you will be much better off with a 100:1 or 50:1 leverage and a larger amount of money to work with. At the very most, you should never trade with anything over 200:1 leverage. To calculate how much money you can trade with any given leverage you can use this simple calculation. 1/leverage = % x lot size = amount of money you need to trade one lot. As an example if I was using a 200:1 Leverage and wanted to trade 1 lot ($100,000 of the currency pair) 1/200 = 0.005 or ½% 100,000 x .005 = $500 I would need $500 on the line for each lot that I traded.