Money management, risk and probability, three of the major overlooked concepts involved in FX trading.

May 23 • Forex Trading Articles, Market Commentaries • 2116 Views • Comments Off on Money management, risk and probability, three of the major overlooked concepts involved in FX trading.

One discussion which many experienced and successful, independent, retail FX traders will enjoy having with other traders, involves what they would have done differently, with the benefit of hindsight? What would they have done back in the day, when they first started trading, based on the knowledge they’ve now acquired? The answers are remarkably consistent.

Understanding money management, understanding risk, realising the impact statistical probability has on their trading all rank highest, as some of the key concepts traders wished they’d have realised affected their trading, as soon and they discovered the industry. Other discussion points involve: patience, realising how long the journey to proficiency and profitability would actually take and how naive they were.

Making your account last as long as possible, during your early learning stage, also ranks high. You’re paying for your unique trader education during this period, which can only be acquired by involving yourself in the FX industry. Therefore, it’s essential that you keep these initial costs under control. Blow up your first account too early, due to reckless behaviour and you could ruin your opportunity, before you’ve given yourself a chance to prosper.

What is fascinating to note, as the questions are posed and the discussion evolves, is very few traders will state; “ I wish I’d discovered my 100% winning, Holy Grail, trading strategy, back in the day, it would have saved me a lot of grief!”. In fact, very few experienced traders point to an initial edge/strategy, having a significant impact on their original trading outcomes. This could be a clue as to where novice traders attention should be focused.

Obviously, developing a strategy, containing an edge, which you can repeat session after session, day after day, is absolutely crucial to your bottom line profitability. But the point is that the edge can’t and won’t exist unless you understand the aforementioned concepts in the article title. And a statistical edge is quite simply the greater possibility of one outcome occurring, over the possibility of another outcome, such a possibility can never be 100%. An edge isn’t as unique as you believe, there’s possibly and probably an infinite number of edges that can and do work, but it’s the: money management, control of risk and applying the edge with respect to probabilities, that ensures the edge is profitable.

Money management.

Think of your money in your trading account as your stock, in a simple business and ask yourself a question; “would you continue to sell your stock at a loss until it’s gone? Would you allow your customers to buy all your produce, for less than you paid for it?” Of course you wouldn’t, it would be a road to ruin in a short period of time. Similarly, in FX trading, you have to discover very quickly, that you need to firstly limit your losses. Give your money to the market, without any sense of caution and control and you’ll be finished.

You exercise self control and discipline by applying limits; you use stops to limit your loss per trade, you use daily limits to cut you loss per day and you limit your trades, you can also limit you profit per trade, to ensure it’s banked. For example; if you’re a day trader you could limit your risk per trade to 0.2% of your account size, limit your losing trades in series to five per day and limit your trades to ten a day. If you lose five trades in a day, right up to your stop limit, then your personal, circuit breaker activates and you stop trading for the day.   

Risk.

When you initially discover trading you must put aside your personal ambitions in relation to visions of wealth. Naturally, you’re impatient to become: competent, proficient and ultimately profitable, but this process can’t be rushed. There are no shortcuts, other than fully immersing yourself into the knowledge base freely available on the web, to avoid the mistakes most traders make. Establish a percentage risk per trade, based on your tolerance and the acceptance that your first account is the price you’re paying for your education.

If you have €1,000, then treat it with the same respect you would a €100,000 account. If you only feel comfortable risking 0.2% account size per trade, the equivalent of €2 per trade, then that’s a perfectly acceptable position from which to trade. If you set your loss limit at 1% per trading day then you’d need 100+ losing days in series to burn through your account and that’s assuming it’s 1% of the original balance. As quantified on a diminishing scale, the time required to burn your account to zero is far longer.

If you have over three months of losing days in series, you’ve discovered an edge that many funds would be only too grateful to share the proceeds with you, by taking the opposite side of your trades. This is a tongue in cheek statement, but you hopefully get the point. You are not going to lose your full limit 100+ days in series, by following the same process each day. You might experience significant losses in series if you keep flitting from one experimental method/strategy each day, which brings you on to the subject of probability.

Probability.

The method/strategy and edge you search for and eventually create, whilst you embed it into your trading plan, has to be underpinned by: money management, risk and your acceptance that probability will be a driving force in your trading outcomes. You don’t have to know what’ll happen next in the forex market, in order to profit from market movements. You have to figure out what the probability is that price will move in one direction, over and above price moving in the other direction.

Theoretically, price will move one of three ways; up, down, or sideways. Your challenge is to figure out the probability of price moving in a direction. For example; certain day traders or scalpers wouldn’t countenance taking a trade which is in the opposite direction of what they perceive to be, the daily trend. If price is above the daily pivot point and or the first level of resistance, they will only trade long. If price is below the daily P.P. or S1. they’ll only go short. This is a crude and basic example of trading with probabilities at the forefront of your decision making.

Moreover, they’ll simultaneously manage their risk per trade in accordance with their money management discipline, by using stops and limits, as part of their trading plan. This basic outline illustrates the relationship between discovering an edge, aligned with money management, risk and probability. Finding a method to marry these four factors up, in order to achieve success, isn’t necessarily the puzzle many traders assume it is at the outset.

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