Once you figure you how much to prudently allocate to your real trading account, you have to strive hard to protect your capital. You must replace your all too human urge for profit with a desire to protect your account from losses. The simple reason: you have to survive in order to win, particularly given the fact that you have a 70-90% chance of consistently losing in forex. You have to overcome transaction costs, a sophisticated competition, the element of volatility and randomness, human emotions like greed and fear, false expectations, inexperience, lack of knowledge, and moreover, you have to construct a sound trading plan and cutting edge system that is married to a professional money management scheme that limits risk and loss. Needless to say, there are so many factors that make it easy to lose in forex, which makes it very important to learn how to properly lose, which is the basis behind sound money management.
To preserve your capital as much as possible, you should follow these two rules:
- Risk only a small fraction or percentage of your account
- Try not to lose more than 25% of your trading account
1. Risk only a small Fraction or percentage of your account
The reason for this rule is that you want to survive, and only once you survive can you make money.
If you don’t have the deep pockets to sustain large losses and continue trading under unfavorable conditions, you must be a skillful survivor. One of the first skills you must learn is to trade with only a small percentage of your account.
Only by risking a small percentage of your account will you be able to withstand the worst case scenario of a 10 trade losing streak.
Let us look at the following chart that illustrates the difference between risking a small percentage of capital and risking a larger one, when each faces the worst case scenario of 10 losing trades in a row:
|Trades||Account Balance Risking 2%||Risking 2% per trade||Account Balance Risking 5%||Risking 5% per trade||Account Balance Risking 10%||Risking 10% per trade|
|10||4169||17% lost||3155||37% lost||1938||61% lost|
You can see that the system that risked 2% per trade suffered the least damage with a 17% loss on initial investment. Any increase above 2-3% results in much more damage: the 5% per losing trade scenario would result in a 37% loss of initial investment, and the 10% per losing trade scenario would result in over a 60% loss of capital.
The table above assumed one is using a Fixed Percentage position sizing model whereby the trader is increasing, or in this case decreasing, position size based on a pre-determined percentage risk per trade and one’s stop loss distance. The risk is the same percentage of account equity on each trade and is related to the stop loss. When the account equity increases due to accumulated profits, the position size increases proportionally, and the reverse happens when the account equity decreases. To properly calculate this method, refer to our article: Position Sizing.
While it is one of the best methods that directly incorporates trade risk, the method cannot be applied to trading strategies with varying or unknown in advance, exit price levels. If your trading system varies the exit based on the indicator conditions it uses to exit a trade, for instance, then you would be better off with the %Equity or Fixed Ratio position sizing models. When you choose these other models, you should still seek out the parameter that will calculate the least risk. With %Equity, you will want the %Equity to be as low as possible, no more than 2% of your account, and with Fixed Ratio you will want your delta to be as high as possible, in order to account for your worst historically back tested maximum draw down scenario.
2. Try not to lose more than 25% of your trading account
The first thing you should strive for when adjusting for lot size and stop losses is that you do not want to lose more than 25% of your equity.
A maximum draw down of anything more than 25% becomes extremely hard to overcome.
Let us look at a table that illustrates this point:
|Needed Return to Recover|
|$10,000||25%||$7500||33% of new balance ($2500) to recover losses|
|$10,000||50%||$5000||100% of new balance ($5000) to recover losses|
|$10,000||75%||$2500||300% of new balance ($7500) to recover losses|
|$10,000||90%||$1000||900% of new balance ($9000) to recover losses|
As you can see, if a trader or system were to lose 50%, he would have to earn 100% on his remaining capital, an extraordinary feat, in order to break even. If he experienced a 75% draw down, the trader would have to quadruple his account, an even more improbable feat, in order to recover back to normal. Try on a demo account to earn 100% of original, and you will see that it is exceptionally difficult. Basically, the more you lose the harder it is to make back your original investment. You have to do everything reasonably possible to protect your account.
The only losing number above that looks reasonable is 25%, because if you lost 25% of your capital it takes 33% return to recover. To achieve 33% would be hard but not impossible. Thus, trying to keep your system below 25% max draw down should be your goal. This goal can be achieved by risking less on each trade, which translates into trading only a small percentage of your account on each trade.
How do you know what maximum draw down your system is capable of achieving?
What I usually do is prepare a back test using 1 mini lot on a $10,000 demo account for the system, which is in effect using 1:1 leverage or no leverage at all. A back test should be conducted over 3-6 years and over a large enough sampling of trades and bars. It is so much easier and more reliable if your system has been codified into an Expert Advisor; then you can perform a historical backtest within 5 minutes using MT4’s strategy tester.
If your system has not been codified into an EA, then you have to faithfully look at all worst case scenarios of your system in historical charts, which can be very time-consuming and can be subject to interpretive bias. With any manual system you create you will have a bias for seeing only its wins and ignoring its losses. It can be very hard to accurately reconstruct more than a few months back test for a manual system.
Providing that you are able to accurately determine the historical draw down of your automated or manual system based on back testing, it is best if you also multiply that historic draw down by a factor of 1.25 in order to realistically anticipate that any forward test will be 25% worse than its historical test.
If, after back testing your system with 0.1 lots on 10K, you find that your system creates a 25% draw down, then you know that your 0.1 lot per 10K account size ratio is a good starting point. If the draw down is greater you need might need a more conservative lot sizing technique, and if it is much less, you can use more leverage. Please go to our article on Position Sizing to determine the best position sizing model for your system with its respective draw down taken into account.
The advice, “Try not to lose too much money,” is simplistically cogent. All traders make mistakes and have losing trades. It does not matter whether you are trading 5000 bushels contracts in a futures pit or small lots of forex online. Every trade will not make money and losses can be expected. The worst thing that can happen is that after some initial success with small size trades, you think you are a trading ‘natural’ and you take more aggressive positions, only to find that honing your trading skill is still a work in progress.
There are no short courses in learning how to trade, and there are no graduation ceremonies because this is a never ending school. You flunk out of school when you lose your trading capital. Sometimes this will happen and when it does, it’s best to take a step back, analyze what you did, and why it went wrong.
It is crazy holding on to a position forever simply to avoid taking a loss. You are trading to make money, and there will be losing trades, even among the best traders. Get over it!
Once you start to lose, it seems like everything that can go wrong does. You remember where the market has been, interesting but irrelevant. Money is made by anticipating where it is going, not by wishing or dreaming how much money you would have if you had cashed out at the higher levels. Money begins to fly out of your account so fast that it makes you sick, sort of like a disease called losing trade influenza. If you diagnose the losing trader’s disease early, you might end up with a very mild case, but if you wait, wish, and hope things will get better, the disease may be terminal.
Finally, you should try not to lose too much money and keep your draw down less than 25%! Learning to trade is like going to a class that does not end. There is no graduation, and there are always new lessons to learn. As time goes by one learns that keeping money can be more difficult than making it.
It has been said that the professional traders can take positions on the wrong side of the market and still come out ahead due to professional money management. I wouldn’t grant that much power to money management. It is your system that has to get the direction and timing right, and so it should be the one that gets the lion’s share of the credit or blame for being consistently right or not on the entry and exit. If your system puts you on the wrong side of the market, money management will not make you profitable; at its very best it can just mitigate your losses. One must always be aware that losing trades, no matter how good the system, are inevitable, and streaks of losing trades are highly probable. Good money management can limit the losses with conservatively adjusted lot sizes and stops so you can survive and recover from the inevitable draw downs.