This comes after years of creating and testing trading strategies, to be more precise, I got more in-depth with money management, when I started developing automated trading software, or when I tried to automate my trading strategies.
What I found out, is that money management can make a bad trading strategy perform positively, or a good strategy under-performs, and all this can happen with just a small change in stop loss or take profit size.
The following statement is a personal opinion, and it is OK to disagree.
- Money management is not to be confused with a trading strategy, because a trading strategy is focusing on entry ( by choosing the momentum thru different indicators, etc.) while money management is focusing on exits.
The exit is not just about having a take profit and stop loss level. Money Management is much more than that, it is an art in my opinion. You need to consider the risk to reward, volatility, scale in and scale out, break even, where to exit and why, and where to scale in or out, and why. So yes, in my opinion, money management is a very complex part of trading, the same as complex as a trading strategy.
So, I will say that a trader’s job, is to find the perfect balance between money management, and trading strategy. Not the perfect entry, and not the perfect exit, but the perfect balance between entry, and exit.
Let's take the following statement:
- A big Risk to Reward, is going to cover more losing trades, and make money long term -
That is true, but is it realistic? How many winners are needed to cover losing trades, with a big Risk to Reward?
What I mean by this, is that if your risk to reward is not realistic, like for example is outside ADR, or is having a strong support or resistance area in its way, your chances of getting take profit hit are drastically reduced, and so, you might not get enough wieners to cover for the looser.
There is a probabilistic reality, that the bigger the risk to reward, the lower the chances of getting it hit. And this is what I am trying to prove, with the following chart.
Let’s start with the following trade example. At any price, and at any given time, you will get a 50% chance of success for your trade, with a 1:1 risk to reward.
The only issue with this statement, is that even though it is true, the string of winners and looser can not be controlled. Mark Douglas in his book Trading in the zone, is given a similar example, with a coin toss. But the idea is that after a certain number of trades, you should be on break even.
Now, please look at the following drawing. There is a strong direct correlation between the length of taking profit, and the chances of getting it to hit.
If you get a 1:1 risk to reward, you have an equal 50% chance of getting take profit hit, but if you have a 1-5 risk to reward, then you are reducing your chances to a total of 16% win rate, for the same strategy. That means that out of 100 trades, you need 16 winners to be on break even.
On the other side, if you are doubling your risk, for a 1-part reward, you are going to get a 66% chance of having TP hit, which is great. But that means that you will need 66 winners out of 100 trades, to be on break even, and this is not the best scenario you wish to have.
According to this example from above, what you need in order to make money, is to find an edge that will give you an extra 1% on top of the given percentage.
For example, at a 1:1 Risk to Reward, you need a win rate of 51% in order to be profitable. Of course, this is just an example to point out the mathematical perspective. Because there are also other costs you need to cover like, commissions, spreads, slippage, Etc.
In the chart above, there is written in the red box, the risk taken for a reward. So the meaning of that, is to point out that the more you go for a higher Risk to Reward, the more risk you are going to get, so the probabilities of reaching your desired target are reduced.
Here are 3 things to consider for money management, in order to improve the performance of a strategy.
1. Market Volatility. Average daily range, ADR, and Average True Range, ATR.
If you choose to have your Stop Loss as fixed size in pips, your performances will be considerably different than if you use ATR for your Stop Loss.
Also, if your Take Profit is higher than the daily average move, ADR, that an instrument has on a daily basis, then you might have problems reaching that Take Profit.
If you trade longer term, I suggest averaging the weekly range as a reference for Take Profit.
You can see from this chart, that 150 pip makes sense in the Asian session, but is less than half in the overlapping London and New York sessions. So keeping a fixed Stop Loss without adapting it to ATR, might not be the best thing you want for your money management.
2. Your Risk adversity.
If you set a 5 times Risk to Reward and your trade is hitting Stop Loss after it was in your favor 4 times Risk to Reward, can your stomach handle this long-term? Or maybe you want to close trades fast after 1 or 2 Risk to reward.
3. Patience.
Can you stay in a trade for 1 or 2 weeks, just to have your SL hit?
Unfortunately, markets are moving against traders at any given point, and the only ONE thing that increases the chances of winning, is the probability of a past event, repeating in the future (given it by an indicator or price action).
So finding that event, that will give you a positive edge, is what will make you profitable long term.
In conclusion, is it worth it to go for a longer Risk to Reward, or not?
That depends on each individual strategy, and of course the market conditions. For an intraday strategy, you can not hope for a 10 times Risk to Reward with a Stop Loss of 100 pip if the ADR is 100 pip. Yes, you can have it hit, but that means that you will need to adapt your strategy for the long term.
Small tips on how to increase your strategy win rate:
1. Find some historical events with a repeating probability, with a minimum of 30%
2. Add indicators that will help you reach a recommended minimum of 50% repeatability of that event.
3. Start trading for a period with only 1 Risk to Reward, and then gradually, increase. Like this, you will find out also what works better for the strategy, and also what your stomach can handle.
I have manually tested the historical accuracy for the following events, over a number of 50 simulated trades, with 1:1 Risk to Reward and a Stop loss of 1 ATR, on a 4-hour time frame, on Euro USD.
1. RSI divergence – In the oversold and overbought areas-
36 Wins and 14 Loses – 72% winning Accuracy
2. MA 9 and MA27 Cross –
25 Wins and 25 Loses – 50% Winning Accuracy
3. MACD – volume convergence/divergence –
33 Wins and 17 Loses – 66% Winning Accuracy
NOTE: The results of the above accuracy example, are done after a personal analysis, and it might be different from person to person. Before adding an indicator to your strategy, I strongly advise, that you should back-test it yourself, because the results are always relative to each individual. We all have different personalities, creativity, etc, so the results will be different.
Scale in and scale out examples and reasoning.
The following examples, are my personal preferable money management strategy for scale-out and scale-in, and I strongly recommend back-testing yourself.
1. Scale in for late entry.
This is a trade example that I took on Canadian Yen. The reason I am adding to losing, is that I need to enter late in the trade, for different reasons. For example here, on Monday’s open, I was not sure that the price will retrace for a perfect entry, so I opened the trade with half of the usual risk, and the other half I was planning to add if the price would have retraced more. The retracement did not happen, as I suspected, so I ended up with a winning trade.
Regarding scale-out on losing trades. I will never scale out from what might be losing trades. I will always put the bet and accept the risk for my analysis.
2. Scale in for winning trades.
You always need to consider if the length of your take profit, is realistic. I personally do not add to my position, but there are two ways you can do that. You can add to fixed pip size or you can add on retracements.
Note that moving stop loss on break even, or adding a trailing stop to it, might be a good idea to keep your trade on positive.
Another way to scale in, is to simply ride the trend and take the profit on fixed risk to reward, like in the following example.
3. Scale outs, on profitable trades.
I am personally not a fan of scaling out from a 5 Risk to Reward position, which will end up with the same reward as a 1:3 risk-to-reward trade to start with. In the following example, I am explaining my opinion on this. You can see that after scaling out 25%, every time the trade moved 1 R, in my favor, I ended up with the same money as a 1:3 trade
So in conclusion, what you need to do is you need to work hard, study hard, back-test what is best suitable for you, and then repeat, because what is working for me, might not work for you, so you need to discover what is working the best on your personality.
I hope this was useful for you guys.
Don’t stumble trading! Trade Safe!
It is very important to keep a constant volume related to your balance with every trade, and not as pip size. When someone is saying i have made 100 pip on that X trade, is totally nonsense because, depending of the traded instrument, 100 pip with 1 lot, can be 1000 USD, or with 0.1 can be 100 USD. And if you account is 10k, than it is very important how you manage the traded volume.
In the above example, with EURUSD, you can see clearly that for a 0.10 lots with a 500 pip SL, you will lose 50 USD, and with 0.2 lots on a 250 pip SL, you will lose also 50 USD.
So, your risk to reward is useless if you do not loose the same amount of money with every trade. I know that you should not focus on money when you trade, but volume traded and money risked for trade, is strictly correlated Risk To Reward Ratio.
There are plenty of software that will do that automatically for you when placing a trade, so you do not need to panic about that.
Please remember this: - Your money risk / trade, needs to be the same with every trade, or else all your trading results will be under the real potential, and your trading statistics will be useless.
IF today on your 1:2 Risk to reward, you risk 10USD to win 20USD, and win, and than tomorrow you risk 50USD to win 100USD on the same 1:2RR, but lose... I think you can all see yourself how wrong it is.