This is a fundamental matter because money management directly concerns the success or failure of trading.
I. Basics of Funds Management
Why is money management so important? Because we are engaged in a profit-making business, and to make money, we must learn how to manage funds. Ironically, the vast majority of traders ignore this aspect of trading.
Strangely, many traders rush into trading without considering their account size or the reasonable amount of funds to use. They simply throw money into the market and press the trade button without hesitation. This kind of trading method can only be called gambling!
If you trade without regard for the rules of money management, it is undoubtedly equivalent to gambling behavior, and it is a typical mindless gamble because professional gamblers pay great attention to probabilities.
Trading behavior without a strategy and the concept of money management cannot achieve long-term investment returns. Money management not only protects us, but in the long run, it also improves our profit level. If you don’t believe what we say and think that mindless gambling is a good way to get rich, then consider the following example:
People who go to Las Vegas always win money, indeed, as they expect, making money in the short term almost doesn’t require thinking. But why do casinos still make money? The reason is simple: gamblers as a whole are losing money in the long run; they just make the casino’s money in the short term and locally.
According to probability theory, only blackjack can beat the casino in terms of probability, and other forms of gambling are undoubtedly biased towards the casino. Even in blackjack, we must master a set of strategies that are advantageous in probability, which are money management and card counting strategies, to beat the dealer. The way of trading is no different from gambling; the essence lies in the mastery and application of probability.
We have to admit that casinos are masters of probability applications and brilliant statisticians. They know that in the long run, they will be the ones making money, not the mindless gamblers. Even if someone wins in a cumulative doubling bet, the casino knows that there will be more than a hundred times the number of people who lose this cumulative bet game, and in the end, the casino makes money.
This is a good example of a statistician making money through gambling. Even if this probability expert loses money, they also know how to control losses to preserve the seeds of victory. Fundamentally, this is the effectiveness of money management.
If you learn how to control your losses, then you will more easily learn how to expand profits. The way of attack and defense lies in first establishing an unbeatable position and then seeking victory.
If you are a genius in probability, then in the long run, you will be the ultimate winner.
II. Drawdown Rate and Maximum Drawdown Rate
Although we already know that money management will help us make profits in the long run, now we want to show you another aspect: what happens if you use the rules of money management?
Consider the following example:
Suppose you have $100,000 and you lose $50,000 of it, what percentage of the entire account is your loss? The answer is 50%. A very simple question. Now, how much percentage do you need to increase to get back to the original $100,000? It’s not 50% now; you need to increase by 100% to get back to the previous $100,000. In this example, the lost $50,000 is the loss amount, which is a drawdown rate of 50%.
The point of this example is that losses are very easy, but making money is very difficult, this rule of probability makes trading not as simple as it seems. You may think that you will never lose 50% of the funds in your account, and of course, we hope so too.
Even if you have an excellent trading system, please consider the following example:
In trading, we are always looking for an advantage. This is also the main reason why traders are committed to developing trading systems. A trading system with a win rate of up to 70% sounds very good, a great advantage.
However, if your trading system has a win rate of 70%, it means that you will have 30 losing trades out of every 100 trades, so is it possible to have 7 to 10 consecutive losses?
It’s not impossible! How do you know which 70 trades out of 100 will be profitable? You cannot determine their distribution.
You may lose in the first 30 trades and then profit in the next 70 trades. We have seen 99 consecutive trades without loss, and to round up to 100, traders are severely trapped until they finally blow up their accounts.
Since it is possible to make money on 99 consecutive trades, why is it not possible to lose on 30 consecutive trades? You need to ask yourself if you can survive and continue playing this game after 30 consecutive losses.
This is why money management is so important. No matter what system you use, if you don’t rely on money management, you may ultimately fail. Even professional poker players have experienced terrible losses, but in the end, they can survive and wait for the final victory.
The reason is that excellent poker players have a perfect money management method because they know that they cannot win every hand, and they only take a small percentage of the total capital to survive effectively and achieve the final victory.
To preserve oneself is to destroy the enemy; as an excellent trader, you are either a military expert proficient in Sun Tzu’s Art of War, a professional gambler proficient in probability theory, or a social psychologist proficient in group behavior.
These are all things that you as a trader should strive to master. A great boxer will benefit from beyond boxing like Bruce Lee was a philosophy researcher; similarly, a great trading master will also benefit from beyond trading, like Soros.
Only when the risks you take are within the allowable range of your account can you be screened by the market, and the market ensures the evolution of excellent traders through natural selection. Remember: if you strictly implement the rules of money management, then you will become the winner of natural selection; you can win!
Now let’s see what happens if you adopt proper money management methods, and what happens if you don’t.
III. Don’t Lose Your Gun
If you risk 2% of your account funds versus 10% of the funds, it has an extremely different impact on the trading outcome. If the risk capital ratio is 10%, when you happen to experience 19 consecutive trading mistakes, your funds will drop from $20,000 to only $3,002, then you will lose 85% of your account funds!
However, if the risk capital ratio is 2%, your account will still have $13,903 left after the above losses, which means you only lose about 30% of the funds.
Of course, if the number of consecutive losses is 5 instead of 19, what will be different? If the risk capital accounts for 2% of the total capital, then after 5 consecutive losses, there will still be $18,447 left; if the risk capital accounts for 10% of the total capital, then after 5 consecutive losses, there will still be $13,122 left, which is much better than the situation of 19 consecutive losses.
The purpose of these examples is to tell you to manage your funds well so that you can still play this game after a period of losses. Can you believe what your account looks like after losing 85%? You must increase by 566% to return to your initial capital level. I believe you do not want to be in this situation.
The more you lose, the greater the effort you need to make to return to your original capital, which also means the greater the difficulty you face. This is one of the reasons why you need to make a great effort to protect your capital.
You must control the number of capitals at risk so that you can still have the strength to win the final victory after experiencing consecutive defeats.
IV. Risk to Reward Ratio
Another way to increase your profits is to enter trades when the potential reward-to-risk ratio is greater than 3:1. If you can find trading opportunities with a reward-to-risk ratio greater than 3:1, you will have a significant advantage in trading.
In this example, you can see that even if your win rate is 50%, you can still make a profit of $10,000. It’s important to remember that whenever you trade, you need to achieve a good risk-to-reward ratio, which will significantly improve your trading advantage, even if you have a lower win rate.
V. Pyramid Positioning and the ‘Thief’ Strategy
Pyramid positioning is a widely known but seldom used position and money management method, especially among many forex beginners who may have never used the pyramid approach to increase their positions.
This position management method was first advocated by the speculative master J.L. Let’s discuss the basic rules and specific applications of this position management strategy, and finally, we will discuss the “thief strategy.”
1. Basic Principles of Pyramid Positioning
The first principle is that you must only increase your position when the existing position is profitable. This rule ensures that you do not increase your position against the trend, as it is human nature to do so, and we must adhere to this principle.
Of course, there is an exception for those who plan to establish the remaining positions during a pullback or rebound, which is fundamentally different from increasing positions against the market: first, it is planned; second, there are strict risk control requirements for replenishing positions.
The second principle is to adhere to a decreasing position size when increasing positions. That is, each time you increase your position, the size should not be larger than the previous position. This is where the name “pyramid” comes from.
The third principle is to control the number of times you increase your position based on the length of the trading wave. In most cases, the number of consecutive increases should not exceed three. In extreme range markets, all positions are established at the time of opening; in extreme trend markets, most positions are added later. That is, in extreme oscillating markets, the number of increases tends to be zero, while in perpetual trend markets, the number of increases tends to infinity.
2. Common Types of Pyramid Positioning
Below are some common pyramid position ratio distributions. The ratio you use should be determined based on market conditions and your personal trading style.
The general principle is that the larger the trading time frame, the more inclined you are to the number and frequency of later positions; the smaller the trading time frame, the more inclined you are to the initial position size; the stronger the market trend, the more inclined you are to the number of later positions, and the weaker the market trend, the more inclined you are to the initial position size.
In trend markets, the more the market runs, the more it demonstrates the strength of the trend, and the greater the probability of continuing in that direction, so our position should increase; in range markets, the more the market runs, the closer it is to a turning point, and the smaller the probability of continuing in that direction, so our position should gradually decrease.
Increase positions with the market in trend markets, and decrease positions with the market in range markets. Below are the position ratios in trend markets:
5 3 2
5 3 1 1
5 4 1
5 2 2 1
4 3 2 1
4 4 2
4 3 3
4 2 2 2
4 3 1 1 1
4 2 2 1 1
3 2 2 1 1
3 2 1 1 1
3 1 1 1 1
2 1 1 1 1
The above numbers represent the size of the position, for example, 5 represents 50% of the position. If the first trade is profitable after opening, you may consider increasing your position at the pullback point for the first time, and the position size of the first increase must be smaller than the initial opening position.
The method for subsequent increases is the same, remember “you should increase at the pullback point, and only when all open trades are fully profitable,” but it is allowed for the position size after the first increase to be equal to the previous increases, but not larger. Generally, do not chase high prices when increasing positions, as this generally carries a greater risk.
3. Benefits of Pyramid Opening and Positioning
The most important function of this operation method is to effectively avoid losses. For example, if you find the market reversing after the first increase, you should clear all positions before the middle price between the first opening price and the first increase price at the latest. Since it is pyramid positioning, such operations are always profitable.
Similarly, if you find the market reversing after the third increase, you can use the same method to cut all the trades from the second and third increases before the middle price between the second and third increases, at least these two trades will not lose money.
You can temporarily retain the first opening trade and the first increase trade, which allows you to continue observing market developments, making it easier to continue decreasing or increasing positions later.
Forex speculators should at least have some basic qualities of a thief. A thief first looks for an escape route and analyzes the maximum possible loss before considering when and where to act.
Based on this “thief mindset,” pyramid positioning should not be done haphazardly. The size of the first opening position should be determined by the opening location, stop-loss position, and the maximum loss that can be sustained, and should not be decided whimsically.
Choosing the opening position based on market development is like solving the problem of when and where the thief will act; choosing the stop-loss position based on the trend pattern is like solving the escape route problem for the thief; the 8% stop-loss strategy is like solving the maximum loss that the thief can bear.
In the forex market, there are two types of “thieves”:
The first type is “never stop-loss”: it’s like a thief who doesn’t run away after being discovered but claims in front of the owner that they will continue to steal, with dire consequences!
The second type is “increase positions as losses increase”: the thief was discovered the first time they acted and did not run away. The owner of the property thought he was honest and only slapped him twice as a memento. He was not convinced, thinking that the failure was due to insufficient manpower.
The second time he went to steal with his wife, and his wife was caught… He still did not repent, did not seriously study the reasons for failure, did not prescribe the right remedy, and did not change the stealing strategy.
The third time he went to steal with his son, and his son was also caught. He became furious, changing from “stealing quietly” to “robbing openly,” and he was caught himself. Increasing positions as losses increase is essentially an inverted pyramid positioning method in the face of losses.
Opposite to the above positioning method is the inverted pyramid positioning method. The inverted pyramid shows the irrational side of humanity. Traders may not be very optimistic about the market when they first open positions, so the position size is relatively small, but the market develops unexpectedly, resulting in high emotions. Under high emotions, traders often forget to choose the stop-loss point first and control the position size under the 8% stop-loss principle.
Once the market slightly retraces, it often causes losses, turning profitable trades into losing ones. Therefore, we believe that if this situation occurs, the first increase can be considered an independent opening action, isolated from the original opening trade for independent operation. Following the normal process discussed earlier, before entering the market, you still need to find a good stop-loss point and adhere to the 8% stop-loss principle for position control, just like a thief looking for an escape route and confirming the maximum loss before choosing the timing to act.
In addition to the pyramid, there is also a practical equivalent positioning method. The quantity of openings and each increase is the same. Using this method, you do not need to consider the 8% loss issue when increasing positions. The thinking is the same as pyramid positioning; when the increase in trade retraces to before half of the previous trade, you should clear the positions, otherwise, you will face losses.
VI. Common Funds Management Techniques
1. Techniques for Matching Margin and Position Size
Before discussing this, let’s correct a misconception about margin trading. Many believe that margin trading is riskier than spot forex trading, which I think is a misunderstanding. This notion equates the leverage ratio in margin trading with the actual risk coefficient of trading, which is a biased understanding.
A forex broker offering 200 times capital leverage does not mean that the investor is taking on 20 times the investment risk. The leverage ratio and trading risk are not directly related; what’s linked to trading risk is the amount of margin in the investor’s trading account and the number of positions opened.
For example, a forex broker offers mini and standard margin accounts: the minimum opening size for a mini account is $10,000, where a 1 pip movement risks $1; for a standard account, the minimum opening size is $100,000, where a 1 pip movement risks $10.
Why is the risk for a mini account smaller than that for a standard account, despite the same 100 times leverage? The reason lies in the size of the positions opened. The larger the position size, the greater the risk to the account, which I believe even elementary students can understand. Yet, some friends who trade spot forex insist that margin forex is riskier than spot forex, which is quite puzzling.
Many newcomers to forex margin trading often ask “Where is it better to open an account, what is the appropriate leverage ratio?” My usual response is “Where to open an account and how much leverage is not the most critical, the risk of investment mainly comes from yourself.” Effective risk control is learning self-control. Back to the main topic, how to match your margin with your position size, our suggestions are:
(1) If the margin is below $500, do not exceed 10,000 in position size;
(2) If the margin is below $5,000, do not exceed 500,000 in position size;
(3) If the margin is below $10,000, do not exceed 1,000,000 in position size.
2. Common Forex Trading Money Management Techniques
First, the money management technique of trading at key levels.
The difficulty in establishing long positions near important support levels:
(1) Determining the strength of that support level;
(2) Strictly buying at the support level can miss opportunities;
(3) Buying in advance often results in a high price, disrupting the risk-reward ratio, and making it difficult to set stop-losses.
Countermeasures:
(1) If the support level is strong, enter the market in advance;
(2) If the support level is moderate, enter the market in batches near the support level, stop loss if it falls below the support level by a certain extent, and increase your position when the price rebounds from near the support level, but the position size for higher level increases should be lighter (i.e., pyramid principle);
(3) If the support level is weak, continue to observe.
The technique for establishing short positions near important resistance levels is the reverse operation, with the same principle.
Second, the money management technique of trading on breakouts.
The technique for establishing long positions when the exchange rate breaks above important resistance levels:
(1) Determine the strength of that resistance level and the probability of a breakout before it happens.
(2) If the probability is high, consider entering the market in batches.
20% of the capital enters before breaking the resistance level;
20% of the capital enters after breaking the resistance level by a certain extent (according to the principle of effective breakout space);
30% of the capital enters when the pullback confirms after breaking the resistance level;
30% of the capital continuously increases positions according to the pyramid principle as the exchange rate rises.
(3) If the probability of a breakout is low, choose to observe and wait to enter after the breakout.
30% of the capital buys after the breakout;
40% of the capital buys after a pullback and turns upwards again;
30% of the capital increases positions according to the pyramid principle after the uptrend is confirmed.
The technique for establishing short positions when the exchange rate breaks below important support levels is the reverse operation, with the same principle.
Third, the technique for closing long positions near important resistance levels.
Difficulties:
(1) Determining whether it’s a trending or ranging market;
(2) Closing positions too early prevents maximizing profits;
(3) Closing positions close to important resistance can miss opportunities.
Countermeasures:
(1) If the resistance is weak, the probability of a breakout is relatively high, and the market is in a trending market.
Close to 10% near the resistance level;
Close to 30% near the resistance level;
Set a stop-loss at a certain distance below the resistance level, close to 60% if the price falls and reaches the stop-loss price;
If the stop-loss price is not reached, and the resistance is broken, forming an effective breakout, then according to the technique of building positions on breaking resistance, the already closed 40% will be replenished opportunistically.
(2) If the resistance level is strong, and the market is in a ranging market.
Close to 30% near the resistance level;
Close to 40% at the resistance level;
Set a stop-loss at a certain distance below the resistance level, close to 30% if the price falls and reaches the stop-loss price;
If the stop-loss price is not reached, and the resistance is broken, forming an effective breakout, then according to the technique of building positions on breaking resistance, the already closed 40% will be replenished opportunistically.
The technique for closing short positions near important support levels is the opposite operation direction, with consistent principles.
Fourth, the technique for setting stop-losses.
(1) Determine the market characteristics, whether it’s a trending or ranging market.
(2) A good stop-loss price is predicated on a good opening price.
(3) In a trending market, operations that go with the trend can have a moderately relaxed stop-loss, but it’s best to intervene in the trend during pullbacks and rebounds, that is, using the multi-timeframe trading guidance we mentioned.
(4) In a ranging market, the stop-loss range for positions can be relaxed, such as during the Asian market when no important news is released.
VII. Eight Standards for Setting Reasonable Stop-Losses
Understanding the importance of stop-loss is only the first step. Specific steps for stop-loss include setting it reasonably and executing it effectively. The reasonable setting of stop-loss must rely on probability management tools and money management principles. There are several methods for setting stop-loss, which need to be used reasonably:
(1) Fixed loss ratio method. Set according to the degree of loss, usually, the stop-loss for speculative short-term buying is set at a 2%~8% drop, while the stop-loss for investment-type long-term buying is set at a relatively larger drop percentage.
(2) Volatility range stop-loss method. Sell when the exchange rate drops from the highest price of the wave by a certain extent compared to the highest price of the wave. If the investor is at a loss at this time, it’s called a stop-loss; if in a profit state, it’s called a stop-win. This method is mostly used for stop-win in most cases. How much the drop percentage should be set for stop-win depends on the activity of the currency, more active currencies should have a larger range.
(3) Technical indicator stop-loss method. Set according to the support level of technical indicators, mainly:
Moving average indicators, such as the 8-period moving average, 13-period moving average, etc.
Bollinger Bands indicator. In an uptrend, the exchange rate crosses below the upper band of Bollinger Bands; in a downtrend, the exchange rate crosses above the lower band of Bollinger Bands.
Parabolic SAR indicator. For long positions, when the parabolic SAR indicator breaks below the turning point; for short positions, when the parabolic SAR indicator breaks above the turning point.
(4) Set based on key positions of significant importance.
(5) Set reference points based on candlestick patterns, mainly:
The tangent of the trend line;
The neckline of the head and shoulders or rounded top and bottom and other head formations;
The lower rail of the ascending channel, the upper rail of the descending channel;
The edge of the gap.
(6) Set based on the integer price level of the exchange rate. This method doesn’t have much scientific basis, mainly because integer price levels have certain psychological support and resistance effects on the investing public.
(7) Set based on the dense trading area. Because the dense trading area will have a direct support and resistance effect on the exchange rate. A solid bottom that is broken through often transforms from a strong support area into a powerful resistance area.
(8) Set the psychological price level as the stop-loss based on one’s experience. When an investor has been paying attention to a certain exchange rate for a long time and has a deep understanding of the exchange rate, the stop-loss set based on the psychological price level is often very effective. However, this method is not suitable for beginners and large capital traders.
Stop-loss is the primary tool for controlling the expansion of losses in forex trading. In its implementation, it is crucial to determine the specific location and timing of the stop-loss before entering the market. One must not wait until a loss has already occurred to consider what standard to use for stop-loss, as it is often too late by then. It is essential to consider how to respond if there is a misjudgment at the time of purchase and to establish a detailed stop-loss plan and criteria. Only by doing so can one be prepared for any eventuality.
VIII. Grid Trading Method Against Traditional Risk Management Principles
The grid trading method has its market because it fits the human nature of adding positions against the market trend. However, this method is used in specific markets. If the market is trending rather than ranging, this method can lead to disastrous results.
Since all financial markets inevitably have trending movements, a single mistake can wipe out all the profits made by this strategy. Of course, we have seen people use this method to profit steadily by improving it and incorporating monthly line research to avoid going against the major trend.
Grid trading should be avoided for news trading, especially when major news releases are released. For example, the release of the Federal Reserve interest rate resolution, the release of U.S. GDP data.
Let’s discuss the specific form of the grid trading method. The most basic form of this strategy is as follows: for example, we go long on EUR/USD and also long on USD/CHF (to hedge and reduce the risk of one-way movement). For going long on EUR/USD: place a buy order every 25 points within a 200-point range above and below the current price, with no stop-loss set, and a profit target of 25 points for closing positions. Similarly, for going long on USD/CHF: place a buy order every 25 points within a 200-point range above and below the current price, with no stop-loss set, and a profit target of 25 points for closing positions.
Check every few hours to see if any buy orders have been executed and closed for profit. Once an order has closed for profit, such as buying at 1.2000 and closing at 1.2025 for profit, then open another buy order at the original price of 1.2000. In other words, ensure there is a buy order every 25 points at all times.
If a buy order at a certain price has not yet closed for profit, do not open another order at that price. You can imagine that if EUR/USD rises, it will trigger a series of buy orders on EUR/USD to close for profit. At the same time, USD/CHF will inevitably fall, accumulating a batch of unclosed buy orders. If the price of EUR/USD then falls back, USD/CHF will rise, resulting in a series of profitable closings on USD/CHF, while accumulating a batch of unclosed buy orders on EUR/USD. If the price saws back and forth within a range, continue to close for profit and open new orders, execute and close for profit again.
The essence of this operation lies in the trading price sawing range; the trading positions are very small. For an account with $1,000, each order can only be 0.1 lots at most to ensure that a significant one-way linear movement does not cause a large number of unclosed losses and lead to a margin call.
The real grid trading method is not a short-term trading system. The larger the range of the net, the smaller the probability of the price running outside the net. However, short-term techniques help establish the grid.
Good short-term techniques can result in fewer orders being hung in the counter-trend direction and using larger positions to profit in the trend direction. This is a necessary prerequisite for the grid trading method to be used in actual combat.
Some people have integrated volatility breakouts, support and resistance levels, dynamic position sizes, multi-layer grids, and trailing stop-losses, which can control the capital drawdown within a very small range. It can be imagined that because the expansion of grid paper losses is exponentially rising in the direction of a trend, if someone can keep the capital drawdown very small, then their profit closing must be very impressive.
In addition, a method called regular grid closure proposed by someone named Jove involves closing the entire grid when the grid’s profit or loss reaches 10%. In this way, he can obtain 10% profits (because the market consolidates more than 80% of the time), and in other cases, only lose 10%.
His method is also worth considering, as it utilizes the advantages of the grid on the one hand and avoids the impact of long trends on the grid on the other.
However, closing the grid is ultimately admitting a loss. If there is a way to deal with the impact of long trends on the grid, then a permanent grid has greater potential in the future. Never admitting loss until closing for profit is the core idea of the grid trading method.
This is just my speculation, and it is difficult to say that there is reliable theoretical support. It can be imagined that after a year, the operating range has reached a new area. In this area, the volume of operations maybe 1-2 times larger than a year ago, and the impact of those orders hung at the farthest end a year ago on paper losses will not be so significant.
As long as it is always ensured that profitable closings continuously increase available funds, the closer the orders are to the current position, the larger their size, and the greater their impact on the account.
The risk of a purely mechanical grid is very high; it can be said that the risk and reward are almost disproportionate, and perhaps a capital of 100,000 yuan needs to be prepared to ensure a final profit of 10,000 yuan.
Advantages of the grid trading method:
(1) No need to judge timing, reducing operational pressure. Timing decisions are the difficulty of all technical analysis, and in the long run, it is unlikely that anyone can beat the market with more than 2,000 transactions based on timing decisions.
(2) Not afraid of market changes. Market participants and the economic environment will cause changes in the market, thereby rendering existing trading systems ineffective.
(3) Any other analysis method can be used within the grid. Any effective method will enhance the effect of the grid, and because of the absolute strength of these three advantages, many people are attracted to it.
IX. Conclusion
To become a professional gambler proficient in the application of probability, remember, that victory only belongs to traders who are proficient in the application of probability! Loss is a very real issue; you will always encounter these problems in trading.
The less risk you take in trading, the less profit per trade. But the greater your chance of survival, which means you will make money for a longer time and thus earn more money, even when considering compound interest.
The more severe your account’s losses, the more difficult it will be to return to the initial capital level, and the greater the effort required.
Take risks with a smaller ratio of capital. Of course, you also need to consider the issue of returns; too little capital or too much idle capital is not acceptable. 3% is the recommended ratio.
Pay attention to controlling the risk-reward ratio. The higher this ratio, the less you should enter trades. Before trading, look for opportunities with an ideal risk-reward ratio; do not enter the market blindly. It is unwise to bear 40 points of risk for 20 points of profit, but often people do so in trading.
We do not recommend the grid trading method, but it is worth understanding because it reveals a potential premise that it must be a ranging market to use this method. You should know the assumptions behind any trading method before using it correctly.