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Thread: MOney Management

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    Default MOney Management

    The Importance of the Risk:Reward Ratio
    Trader A has a win percentage of 75% on all trades while trader B has a win percentage of closer to 40% on all trades. Which trader is more profitable? Of course we can't answer that as we don't know how much each trader makes when they are right compared to how much they lose when they are wrong. So the win percentage is not the most important factor in trading. I'm sure that we would all like to win most of our trades, but if our goal is to be profitable, then there is more to the equation. It is called the risk:reward ratio and is one of the most important aspects of money management and a key to becoming a consistently profitable trader. Let's take a look at some examples:

    If you risk 100 pips and look for 300 pips in profit, your risk:reward ratio is 1:3 or one pip of risk for every three pips in potential profit.

    If you risk 100 pips and look for 200 pips in profit, your risk:reward ratio is 1:2 or one pip of risk for every two pips in potential profit.

    If you risk 100 pips and look for 100 pips in profit, your risk:reward ratio is 1:1 or one pip of risk for every one pip in potential profit.

    If you risk 100 pips and look for 50 pips in profit, your risk:reward ratio is 2:1 or two pips of risk for every one pip in potential profit.

    If you risk 100 pips and look for 25 pips in profit, your risk:reward ratio is 4:1 or four pips of risk for every one pip in potential profit.

    So trader A would not be profitable using a 4:1 risk:reward ratio while maintaining a win percentage of 75%. On the other hand, trader B using a 1:2 risk:reward ratio while maintaining a win percentage of 40% is a profitable trader. I would recommend that new traders use a 1:2 risk:reward ratio in their trading. If you open a trade with a risk of 25 pips, then try to get twice that or 50 pips in profit. I would also recommend moving your protective stop up to breakeven when the market moves halfway to your target. An example of this would be if you bought at 1.2500 and placed your protective stop at 1.2475, your risk is 25 pips. Using a 1:2 risk:reward ratio means placing your limit order to take profits at 1.2550 for a potential gain of 50 pips. When the market moves up halfway to your target which would be the 1.2525 level, you move your protective stop from 1.2475 up to your entry level of 1.2500. At this point, you can only win or break even on the trade. Then you can spend your time looking for the next trading opportunity instead of following the current trade.

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    Default Don't Hold Your Breath Too Long While Under Water

    The headline of this educational feature pertains not to swimming but to trading. Most professional traders do not hold onto their losing positions for very long. Once a trading position goes "under water" most professional traders will immediately begin looking for an exit strategyI am bad and I will be banned-if they do not already have one in place (and most do) via protective stops.

    I had lunch with my trading mentor the other day and he shared a very good story with me. It went something like this: There once was a trader whose trading decisions were based upon using a "plumb-bob." (For those who have never worked on a construction site or in the land-surveying business, a plumb-bob is a turnip-shaped weight that is attached to a string to help determine if a structure is straight.) When this trader dangled the plumb-bob and it swung back and forth from north to south, he would buy. If the trader dangled the plumb-bob and it swung back and forth from east to west, he would sell. The trader had success using this methodology--with one simple rule applied: At the end of the first day, if his position was "under water," he exited his trade first thing the next trading day.

    The moral of the story is: Traders can (and do) have all kinds of trading strategies, but prudent money management is paramount. In other words, cut losses short!

    Over the years I have received emails and telephone calls from traders who were way "under water" and had not prudently liquidated their losing trading positions. These traders were "hoping" the markets would turn around and losses would be reversed. Any time a trader has losses which are so big that "hope" comes into play, it's usually a situation where prudent money management has not been employed.

    It's also important to mention that traders who know they have waited way too long to exit a losing position should not think already-big losses can't get even bigger--much bigger. I've heard many traders say, "Well, I've lost so much already that now I might as well wait for the market to turn around because it can't go much farther against me." That's a recipe for disaster and potential financial ruin. This is where the saying, "Never meet a margin call" comes into play. If a trader gets a margin call from his or her broker, it's best just to close out the losing position and look for trading opportunities in other markets.

    I've often mentioned the old trading adage: "A market will do anything and everything possible to frustrate the largest amount of traders." Guess who are the traders that get most frustrated? It's the ones who are hanging on to losing trading positions, waiting and hoping for the market to turn around so they can get their money back. "I just want to get back to even" is a desperate quote that comes from some traders who are under water. That "hope" is usually never realized.

    One of the most interesting aspects of trading futures is that there are a few basic and effective rules that have been used by successful traders for years. However, adhering to these rules on a continual basis can be most difficult for many traders--including the experienced veterans. Why is this? It is because some of the most effective rules in futures trading go against the grain of human nature. Indeed, the "psychology of trading" plays such an important role in trading success.

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    Default Employing Protective Stops to Manage Your Trades ptI

    There is no absolutely perfect money-management tool in futures trading, although purchasing options on futures does limit your risk of loss to the amount paid for the option. Purchasing options does have its disadvantages, however, and I won't go into that in this feature. What I will focus upon in this educational feature is the placement of protective stops (a sell stop if you are going long and a buy stop if you are going short) in futures trading. Protective stops are not a perfect money-management tool, but they are very effective in helping to solve one of the most important elements of futures trading: When to exit a position.

    Before I discuss the advantages of using protective stops, I want to discuss a disadvantage about which many long-time traders are fully aware: Floor traders in the pits "gunning" for stops. This is a real phenomenon whereby "local" floor traders (those who trade for their own account) think they know where most of the resting buy or sell stops are located, and then attempt to push prices into those stops, set them off, and then let the corresponding price move run its course, only to then take profits on that move and the market price then returns to near levels seen before traders went gunning for the stops. This action by floor traders is not illegal or even unethical--it's just a part of futures trading. These floor traders have to pay a lot of money (or their sponsor pays their fees) to trade in the trading pits on the exchange floor. They do have some advantages over off-floor traders and, importantly, they also provide the needed market liquidity that all traders and hedgers appreciate.

    Floor traders gunning for stops is more an art than science, as market conditions have to be just right for their efforts to pay off. For "local" floor traders to push a market in their desired direction, outside fundamental factors need to be about in equilibrium and not having an influence on market prices. For example, any floor traders gunning for sell stops just under the current market price won't get the job done if there were a bullish fundamental development that would pushes prices higher. Remember, no one group of traders--not even floor traders--can influence market prices very much or for very long.

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    Default Employing Protective Stops to Manage Your Trades PT 2

    Also, sometimes floor traders think they know where stops are located, and when they push a market and try to force a bigger price move, they do not find the stops and then they are forced to cover their trades at a loss.

    A longtime friend of mine and former Chicago Board of Trade grain floor trader, John Kleist-I am bad and I will be bannednow a highly respected grain and livestock market analyst--told me the following about locals gunning for stops: "Back in the 1970s and most of the 1980s were really the 'last hurrah' for locals wanting to gun stops. And it basically was in the 1990s when better (and more transparent) communication allowed important news to filter 'down' to the pits, rather than 'up' from the trading floor. Locals gunning for stops now is usually more effective in illiquid trading pits, such as the hogs or bellies--and less effective in soybeans and wheat, and very difficult in the corn pit. Gunning for stops has been replaced by locals coat-tailing the commodity funds and exaggerating price moves. Maybe that's the same effect but done a different way. Stops have to be relatively nearby current prices--i.e. support/resistance areas commonly used as 'public' stop areas, if the locals are to be effective. And, of course, if near major moving averages in the case of the funds."

    Okay, on to the advantages of futures traders employing protective buy and sell stops. As I said above, the major advantage of using protective stops is that--before you initiate the trade--you have a pretty good idea of where you will be getting out of the trade if it's a loser. If your trade becomes a winner and profits begin to accrue, you may want to employ "trailing stops," whereby you adjust your protective stop to help you lock in a profit should the market turn against your position.

    On specifically where to place your protective stop upon entering a trading position, one of the most popular and effective methods is to find a support or resistance area that is within your loss parameter for that particular trade. Here's an example: A trader decides to go long corn futures and he does not want to lose more than $250 per contract if the trade turns out to be a loser. He should try to find a technical support level that's around 5 cents below the present market price, and then place his sell stop just below that support level.

    I generally use the above formula when I place my protective stops. However, I know that the local floor traders also know where it would be most logical for most traders to place their protective stops. So, I will "tweak" my stop placement a bit to reflect this. For example, if I decide to go long corn and there is a solid support level that is within my loss-tolerance parameter, I will set my protective sell stop maybe a couple cents below that support level. My thinking would be that most other traders would set their protective stops about a penny below that solid support, and if floor traders were going to gun for stops, then they may not be able to hit mine if it's a couple cents below the solid support level. The disadvantage to this theory is that your stop may be hit anyway, if there were a bunch of stop triggered above my own stop and pushed prices lower. Also, my losing trade would be about $100 or $150 steeper per contract than if I had not tweaked my stop.

    Only rarely will I call my broker and change the position of a protective stop in a trade in which I'm "under water"--meaning it's a losing trade at the time. That would defeat the purpose of making your decision on how much of a loss you'll absorb BEFORE you make the trade and are in the heat of battle during a trade. Conversely, on winning trades that I have going, I may call my broker every day and tighten a protective stop, if the market is moving rapidly.

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    Default Some Practical Thoughts About Money Management 1

    We get a lot of questions about various complex money management (MM) formulas and our preferences. We don't comment on this subject very often because money management is such a personal issue that it would be impossible to give any universal advice that would be specific enough to have value. Everyone seems to have different goals and tolerances for risk, not to mention varying amounts of capital for trading.

    However we do have some basic thoughts and opinions that might be helpful in picking a suitable MM strategy that will help you to become a winner.

    Be careful about trying to use formulas that are designed to optimize the returns. In my experience I have found that the most successful traders, over the long run, are not seeking to maximize their returns. The best traders are always seeking to carefully control their risks and to achieve as much consistency as possible. They look for methods to achieve consistent returns with low drawdowns and they are willing to accept smaller returns in the process. My policy has always been to worry about the risk and the consistency first and then to accept whatever returns that prudent approach will allow. I'm sure I will never win any trading contests and I have never bothered to enter one. In my opinion, no one should ever trade like the winner of a trading contest. I apologize for getting off on a different subject here. Lets get back on track and talk about trading in the only contest that matters - the trading that you do every day.

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    Default Some Practical Thoughts About Money Management 2

    In recent years the strategy of risking a small percentage of capital on each trade has become quite popular and deservedly so. This MM strategy, often referred to as fixed fractional trading, reduces our dollar amount of risk as we experience losses and increases our risk level as we earn profits. The possibility of ever going to zero with such a strategy is virtually nonexistent. However this strategy has an inherent weakness that tends to constantly work against us. If we assume an equal number of winners or losers in a sequence this popular strategy produces net losses if the winners are not larger than the losers. To keep things very simple lets just look at a series of five wins followed by five losses with the wins being equal to the amount we risk. Lets also keep the math really simple and begin with starting capital of 100 and risk 5% of our current capital on each trade. I think that most traders would assume that if they had five losers followed by five winners they would be even. Unfortunately that is not the case.

    Here are the numbers: Risk is always 5% of current capital. (I'm going to round the numbers to two decimals.)

    Capital $ Risk W/L Account balance
    100.0 5.00 L 95.00
    95.00 4.75 L 90.25
    90.25 4.51 L 85.74
    85.74 4.29 L 81.45
    81.45 4.07 L 77.38

    OK we are already tired of losing. Let's have five winners in a row and see if we can get our money back.

    Capital $ Risk W/L Account balance
    77.38 3.87 W 81.25
    81.25 4.06 W 85.31
    85.31 4.27 W 89.58
    89.58 4.48 W 94.06
    94.06 4.70 W 98.76

    As you can see we had an equal number of winners and losers yet somehow we lost money. Perhaps it is because we had bad luck and got started in the wrong direction. Lets reverse the sequence of trades so that we start out on a winning streak instead of losing. Maybe that will help.

    Capital $ Risk W/L Account balance
    100.00 5.00 W 105.00
    105.00 5.25 W 110.25
    110.25 5.51 W 115.76
    115.76 5.79 W 121.55
    121.55 6.08 W 127.63

    Looks good so far. Starting off with winners looks much better than starting with losses. But now we have five losers coming up.

    Capital $ Risk W/L Account balance
    127.63 6.38 L 121.25
    121.25 6.06 L 115.19
    115.19 5.76 L 109.43
    109.43 5.47 L 103.96
    103.96 5.20 L 98.76

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    Default Some Practical Thoughts About Money Management 3

    Hmmm. It doesn't seem to matter if we start out with a string of winners or a string of losses. Somehow we wound up losing the same amount of money either way.

    Obviously we don't have a very good system at work here but it is not a losing system. With the proper MM strategy we should break even. Our winning trades are only equal to our risk and to have a winning system the winners need to be bigger than the losers. We are winning on only half of our trades and we would be profitable if we could win on more than half. Even though our system is not a good one you would think that it would at least be a breakeven proposition (we haven't included any costs) because the winners are always equal to the amount at risk and we win 50% of the time. That sounds like a breakeven system, doesn't it? But if we employ the popular money management strategy of risking a fixed percentage of our current capital we manage to turn the system into a loser. However, if we risked a fixed dollar amount on each trade the system results would improve and we would break even.

    The fixed percentage of risk approach to MM is a good one because it keeps us from going broke and it compounds our profits rapidly. Both of those are desirable characteristics but we need to be aware that they come at a price. We should realize that our recovery from drawdowns might not be as fast as we would like and that we can give back profits even faster than we made them.

    One strategy that can help solve the problem of giving back the profits too rapidly is to periodically sweep some of the profits out of the account and place them in some other place where they are adding to our diversification and reducing our risk. Now and then we should take some of the profits out and spend them on something that improves our quality of life. This important step gives the dollars at stake a new meaning and boosts our morale tremendously. What is the point of winning and losing and accumulating profits only to give them back at some later date? If we make it a practice to routinely sweep some of the profits our account will continue to grow but it will be compounding at a slower rate than if we left our profits at risk. However if we stumble into a losing streak we will be glad that we took out some of the profits and reduced our bet size.

    If we are good traders and we make it a practice to withdraw some of our profits on a regular basis we will eventually reach the point where we have taken out more than we started with. There are very few traders, particularly in futures, who can claim that they have truly beaten the market. Until you have taken out more than you started with the market can still beat you. Trading futures is a zero sum game and winners are few and far between. Taking out profits now and then rather than getting carried away trying to optimize the gains to infinity is contrary to what is being taught these days. Everyone is obsessed with finding formulas to optimize the returns. We need to remember that the trader who has the optimum gains today could easily be tomorrow's biggest loser. That is a game we don't need to play.

    I think we all need to take a step or two back and look at the big picture. Trading is not really just a game. The money is real. Lets make sure that we are true winners and not just habitual players. Take some profits now and then and put them out of harms way. When we have done this I can assure you that the game is a lot more fun and our trading will improve. Nothing builds confidence like knowing for sure that you are indeed a winner.

    Good Luck and Good Trading

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    Default Seven Time-Tested Money Management Rules to Insure Survival over the Long Run

    . Always Preserve Capital. Traders should limit loss to 1% of total capital for any one position.

    2. Always trade in the direction of the larger trends, with the most emphasis on the Primary Tide that lasts many months or years. In a Bull Market, look only for opportunities to enter long and close long. In a Bear Market, look only for opportunities to enter short and close short.

    3. Always use Actual Stops. Short-term traders should limit losses to a maximum 2% for each position. Longer-term traders and investors should limit losses to 7.2% on the long side and 8.4% on the short side for each position. (See my book, Swing Filter, pages 680-681, and Cycles, pages 178-179.)

    4. Always exit losing positions before the close of the day for short-term Ripple traders (with a time horizon measured in days). Longer-term traders should also set a time stop appropriate to the cycle they are trying to capture, in order to avoid tying up capital in positions that are not moving as expected. (See my book, Cycles of Time and Price, pages 176-188.)

    5. Always consider Bet Size and Diversification. Commit a maximum of 5% of total capital to any one position.

    6. Always calculate your Reward/Risk Ratio. Enter a position only when your analysis indicates 3 points of potential reward for 1 point of risk.

    7. Always take a time out from trading any time you lose 5% of your capital. This breaks bad momentum and limits negative spirals into deep holes. It gives us time to calmly reevaluate the situation. A few days off helps clear the head. A time out helps limit revenge trading. The desperate attempt to quickly make back the loss most often causes even more trouble.

    Capital conservation should be the first rule in trading and investing. Capital takes time to accumulate, but it can disappear fast if the technical trading rules are not well known and respected. Beginners particularly would be well advised to take these rules to heart and to start trading only a small fraction of their capital using the minimum size orders until they acquire their real-time market education as inexpensively as possible. Ignore

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    Default Buy the Strongest, Sell the Weakest

    One of the best technical tools we can use in our analysis is the status other currency pairs. If you are of the opinion that because of fundamental reasons the US Dollar will weaken, your next step would be to find the currency pair that gives you the best chance for a profitable trade.

    Instead of automatically picking a pair like the EUR/USD and placing a buy, you might want to take a look at some of the crosses to see which currency is currently the strongest and play that one instead. An example would be to first check the chart of the EUR/GBP. If this pair is rising, that means that the EUR is currently stronger than the GBP and buying the EUR/USD would be preferred. However, if the EUR/GBP is falling, then the GBP is stronger than the EUR and buying the GBP/USD would be preferred. You can also add the CHF into the equation by first checking the EUR/CHF and the GBP/CHF. You should get a good idea of which of the European currencies is the strongest of the three and trade that currency against the weakening USD. The idea is to buy the strongest currency against the weakest to increase your chance of success

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    Default

    THANKS RICHTRADER for the educative threads,phsycology in trading is the most important aspect of trading...........

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    Default

    SO WHAT MONEY MANAGEMENT YOU use to trade with?

    4:1 or 3:1 ?

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    Default

    i use 3:1,smtimes 3:1

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    Default How Many Times Have You Exited a Position Early?pt1

    Do you have a problem with exiting your positions too early? I always have. It's one aspect of my trading that concerns me because I'm never sure if closing it early was the smart thing to do. Let me give you an example which just happened to occur today. I went long on the EUR/CAD before the European session open. I went to bed and woke up to see the position up 80 pips. I had a 100 pip stop loss and a 200 pip target. I was a bit surprised to see it up this much so quickly. I thought about it for a minute and decided to close the position and take the profit. Why violate my pip target? Based on my experience with the ebb and flow of the currency market, I figured there was a good chance that the price will not continue in my direction and retrace, wiping out any profit I had. I've seen this happen so many times. Today, this didn't happen. The EUR/CAD continued going up and would have easily hit my 200 pip profit target. This frustrates me more than losing. Here are a couple of ways I've handled a position that goes in my favor by a substantial amount:
    Close it out based on feel or maybe fear. I'll do this even if I have a target set on the position. My rationale for closing it is that either I'm satisfied with the amount of profit or I'm fearful that if I don't, the pair will turn against me and wipe out my profit.
    Close a portion of my position based on feel or fear and leave the other portion open to run if the pair continues in my favor. From my experience, when I do this, more times than not, the remaining portion gets stopped out and I lose the profit. Almost always, when I close a portion of my position for profit, I'll set the stop to breakeven on the remaining portion so I won't lose any money.
    It runs to completion and my target price is hit. This almost always occurs when I don't have time to monitor the position. The target price usually gets hit very quickly. I typically obtain my highest reward to risk in this scenario

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    Default How Many Times Have You Exited a Position Early?pt II

    In scenario #1, I feel good about the trade if I close it out and then it does exactly what I thought it would, turn against me. I don't feel so good if the pair continues in my favor after I've closed it and would have hit my target.

    My feelings in scenario #2 and very similar to those in scenario #1.

    In scenario #3, I feel great about the results of the trade.

    So which is better, any of the three scenarios or flat out losing money on a trade? I think not losing money is best but the first two scenarios can sometimes lead to losing money. If I'm not getting a decent reward/risk because I'm exiting a position too early, when I do hit that losing streak (trust me, it will happen), my losses could be much greater than my gains. How many times have you closed a position early when it at a negative and not going in your favor? I can count the times on one hand.

    I'd love some feedback on what your experiences are and if you can relate to my possible problem. It hasn't affected my profit the last month and a half though. I'm up over 13% this month alone but like I said, this could be short-lived if I don't address this now.

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    Default 2 Percent Risk with 2R Multiple

    I've been emulating my real account trades with my demo account for the January forex trading contest. I'm currently in first place with a return of 11.16%. After today though, my return will drop 2 percentage points to about 9% since I lost 2% on a trade. I don't know if this will be enough to hold on to the lead.

    This is an overview of how I've been trading so far in January 2008:
    I have been risking exactly 2% on every trade. No more, no less.
    I've been using my forex position size calculator everyday when figuring out my trade size and find it very handy. Some of you have commented the same.
    My R-multiple on every trade has been 2R. For those of you that haven't heard of R-multiple, it's really just an abbreviation for reward-to-risk. 2R means my reward-to-risk is 2:1.
    I'm not watching my positions so there isn't any fancy money management going on. I haven't once set my stops to breakeven. I'm just letting them ride. If they hit my target, they hit it. If they don't and stop out, so be it. This is quite different from what I've done in the past. In the past, I've been quick to set my stops to breakeven when they move a little in my favor. The consequence of doing this was typically a gain/loss of zero. I can't tell you how many times I've moved my stop to breakeven only to see it get stopped out. Then I have to watch as the price goes back in the direction I was trading where it hits my initial target price. This to me was more frustrating than losing. I'd rather stick to my guns on a trade instead of playing it scared.

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