It seems that every time I look for good information on Forex money management I am given an explanation of how it keeps your risk under control. While every trader needs to control risks, that is far from being the whole picture.
You see, the whole reason people get involved in speculative markets in the first place is to obtain a better ROI (Return On Investment) than they would using more conservative investments such as CD's, Bonds, or mutual funds. This means that you are interested in speculating in the Foreign exchange markets because you are seeking above average or well above average returns, right?
One big reason that the currency market is perfect for speculation is the level of leverage. Naturally, leverage makes it possible to grow your money faster than if you used no leverage at all or if you were buying stocks on margin with a conservative 2:1 leverage. What money management does is give you an additional type of leverage by making your money work more efficiently for you.
The best way to illustrate the power of money management is through an example. We will use two fictitious traders named Peter and Paul:
Paul decides to use the EURUSD currency pair as his financial instrument of choice. Paul's system is good and he makes $1,000 per trade starting with a $10,000 account. Paul trades 1 contract per trade for a total of 30 trades. His total equity is now his original $10,000 starting account balance + 30 x $1000 profit = $40,000. Without going into great detail, we can simply say that Paul is doing well.
Peter starts with the same amount of opening account equity, $10,000. Peter is using the same basic system as Paul. He makes $1,000 per trade per contract, but varies the number of contracts he trades based upon his available equity. For Peter's 30 trades his total equity is now his original $10,000 starting account balance + $766,000 profit = $776,000.
What did Peter do differently than Paul to grow his equity to a level 19 times greater than Paul's? That's a good question! Peter used a different strategy and allocated his capital using “position sizing”. In other words Peter varied the number of currency pair contracts he traded based upon his equity. Once his equity reaches a certain level Peter then allocated $5,000 for each new contract traded. Peter did not start adding contracts until his equity had reached the $15,000 level and then added a new contract with each $5,000 in additional equity.
There are numerous effective money management techniques that you can use. What I have just shown you was an oversimplified example strictly used for the purposes of illustrating the incredible power of position sizing. This simple example is referred to as “fixed dollar amount” technique because we increase or decrease the number of contracts based upon a fixed dollar amount (in this case that amount was $5,000). Techniques such as these can make any good trading system better. With that said, it stands to reason that it is imperative that you have an excellent trading system to begin with. Properly applied, a money management strategy can truly skyrocket your equity.
Leave a Reply