Home»Trading»Money Management»The Money Management Principle Most Traders Don’t Know About

The Money Management Principle Most Traders Don’t Know About

6
Shares
Pinterest Google+

The more I surround myself with great traders, the more I learn…Even when it comes to money management!

As I mentioned in a couple of articles, my start as a Forex trader was rough and I really learned everything on the spot.

There comes a time, however, when you think you have mastered a particular topic. I spent so much time reading books and researching online. I thought I had mastered money management so well.

Now, fast-forward a few weeks ago.

I got an email from a trader, the Forex Trading Coach Andrew Mitchem. I started reading, as I always do.

The email discussed the importance of using percentages instead of pips.

Wait…what?

I had never heard of that notion before but it really stuck in my mind as a money management principle. The best part about it is that I see a lot of potential in this technique. Let me explain a little more…

Why are pips wrong?

A “pip” is a measure of movement in the price of a currency. However, it does not consider what that movement represents in relation to your trading account.

Let’s take a very simple example to make everything clear. Suppose you take 3 trades all on the same currency pair :

Trade 1 (winning): 

Stop loss distance: 50 pips
Take profit distance = 100 pips
Profit/Loss = $100

Trade 2 (winning): 

Stop loss distance: 25 pips
Take profit distance = 50 pips
Profit/Loss = $50

Trade 3 (losing):

Stop loss distance: 100 pips
Take profit distance = 200 pips
Profit/Loss = -$200

Total profit/loss = $-50

In this example, you’ve followed the traditional money management principles. You have a Reward-to-Risk of 2 for each trade. You also had more winning than losing trades.

That’s all great but you still had a loss…

This is because you did not consider the size each stop loss would have.

In trading, we can’t assume that our stop loss always will remain at the same distance from the entry for every trade. We may risk 50 pips here, 20 there, and 100 in another trade.

Even though we set a Reward-to-Risk that is appropriate, we could lose more on a single trade than a few others combined.

What you should do instead

Instead of looking at the number of pips you gain or lose, we’d better look at the percentage of our account that is at risk. And the key here is to make that percentage constant for any trade.

Let say you have a trading account of $1,000. You decide that your maximum risk per trade is 2%. Then, whether you have a stop loss of 25, 50, or 100 pips, you will still be risking the same amount of money.

Here would be the outcome of the previous example:

Trade 1 (winning): 

Stop loss distance (2% of $1000): 50 pips ($20)
Take profit distance = 100 pips ($40)
Profit/Loss = $40

Trade 2 (winning): 

Stop loss distance (2% of $1000): 25 pips ($20)
Take profit distance = 50 pips ($40)
Profit/Loss = $40

Trade 3 (losing):

Stop loss distance: 100 pips ($20)
Take profit distance = 200 pips ($40)
Profit/Loss = -$20

Total profit/loss = $60

As you can see, you’ve decreased the amount risked in each trade but you’re getting a better profit. The best thing is that as long as 33% of your trade bring you twice the stop loss distance, you will not lose money. In other words, you can afford to lose 2/3 trades if you set a Reward-to-Risk of 2.

Here’s the perfect tool

I was amazed by what I learned simply by reading one email. Andrew Mitchem, the trader & coach who sent this email really had something solid.

Update: Andrew Mitchem has been interviewed in episode 1 and 104 of the Desire To Trade Podcast.

However, I must acknowledge that calculating the percentage by hand is quite painful and confusing. If that’s what it takes for proper money management, I’m up to do it!

Andrew created a very great tool you can use to calculate everything automatically in Meta Trader 4. You simply enter the percentage you want to risk and the size (in pips) of your stop loss. Then, a nice popup appears to tell you how many units you should trade for a particular pair. The best thing about it: you simply need to enter your email and can download the tool for free!

Click here to get Andrew’s Position Size Calculator for free

Get the right money management principle in place

Whether you want to calculate it by hand or using a tool like Andrew Mitchem’s calculator, I strongly recommend using percentages when you decide how many units to buy. As we’ve seen, using pips can be very misleading. It can even prevent you from making money, meaning it’s worth giving percentages a try.