START – Money Mgmt

How to protect your capital

Money management is a concept that protects your trading capital from losing trades and it is the most important skill for trading. This lesson will demonstrate the importance of applying prudent risk management to avoid large losses that can lead to you losing your entire trading account.

Money management, also called risk management, is a core concept that you should start with immediately when you begin to learn and it should be the very core focus throughout your trading career. It will allow you to deal with performance downturns and it will preserve your trading account during these times, enabling you to carry on trading.

The core principle of money management is that you should only ever risk a very small portion of the money that you have to trade with on any single trade. Many professional traders do not advocate risking any more than 1% to 2% of an account on a single trade. Limiting your risk per trade to a maximum of 1-2% of your whole account greatly reduces the effect of losing streaks, as you will preserve the majority of your trading account.

Risking only 1% on each trade means you can lose twenty trades in a row and still retain over 80% of your starting capital. If you were to risk 5% per trade, after twenty losing trades there would be less than 40% of your original starting capital left. The table below shows you the effects of only risking 1% or less on each trade against risking 5%:

After losing twenty trades, the account is reduced to $16,523 after risking only 1% on each trade; risking 5%, the account balance is reduced to $7,547. After twenty trades, by risking 5% on each trade, the trader now has to make over 100% of the account just to get back to the original starting capital. Simply by adhering to risk management, an account can survive longer drawdown periods and still be able to trade.

The Risk Reward Ratio

The risk to reward ratio is how much capital a trader is willing to risk in order to gain the potential reward on the trade. You can use either a monetary value or pip value when calculating the risk to reward. For example, if you are risking $1 to potentially make $2, the reward is divided by the risk and so the risk to reward ratio is 1:2. If you are risking 30 pips on a trade and have a 300 pip profit target, the risk to reward ratio is 1:10.

When looking to take a trade, you should always make sure that your potential reward is larger than your potential loss. The following chart shows you a real example of how this may look. The chart shows the stop loss, shown as 1, the entry, shown as 2 and the profit target shown as 3. The distance between the stop loss and entry, shown as 4 is 40.4 pips away. The distance between the entry and the profit target, shown as 5 is 88 pips away. This means that the risk to reward is over 1:2 for this trade.

Stop loss
Entry
Profit target
Distance between entry and stop loss is 40.4 pips
Distance between entry and profit target is 88 pips

Stop Loss & Profit Targets

Any time you consider entering into a trade, you should not only have pre-determined where your entry will be, you should also have pre-determined where your stop loss and profit target will be. Once you know where your stop loss and entry point is, you can calculate the risk and potential profit on the trade.

As a general rule of thumb, you should aim for a risk reward ratio of 1:2 or better. If you maintain a risk to reward ratio of 1:2 then you only need one-third of your the trades to win to remain break even. The risk reward ratio is closely connected to the percentage of your trades that end up winning. The risk reward ratio itself does not automatically mean success. Even a risk reward ratio of 1:4 does not help you if less than 20% of your trades end with a profit. So the risk reward ratio has to be seen as an aspect of an overall trading strategy, and not in isolation.

A great way to improve your effective risk reward ratio is using trailing stops, as they will make sure that in many trades that end of losing, your are losing less than the amount originally set for your stop loss.

What is the cost of trading?

The cost of trading is the overall expense that a trader has to incur in order to run their trading business. There are optional costs for things that the trader may wish to purchase, such as news services, custom technical analysis services and faster connections, and compulsory costs, which are expenses that every trader must pay.

The cost of trading is the overall expense that a trader has to pay in order to run their trading business. For every trade that you place, you will have to pay a certain amount in costs or commissions for each trade that you place with a broker. These costs vary from broker to broker, but they are usually a relatively low amount. These are usually the only cost of trading that you are likely to incur.

This may sound like a simple enough process, but many traders overlook these costs of trading and thus underestimate the challenges to generate a long-term profit. For many forex traders, failure to make a profit is not always down to not being able to trade well – sometimes a mismanagement or underestimation of the costs involved can lead to failure when the trading results should, in theory, lead to success. By taking a look at the main costs of trading, a trader can be more prepared to manage their capital.

What are spreads and commissions?

Remember: Costs vary from broker to broker, so make sure that you check the rates on offer before placing any trade. Many retail brokers, for example, do not charge direct commissions, instead adding their costs onto the spread. The most common costs associated with trading are the spread and commission fees charged by the broker for each trade placed. These costs are incurred by the trader regardless of how successful those trades are.

The easiest way to understand the term spread is by thinking of it as the fee your broker charges you to trade. Your broker will quote or give you two prices for every currency pair that they offer you on their trading platform: a price to buy at (the bid price) and a price to sell at (the ask price).

What is a Spread in Forex Trading? - BabyPips.com

The spread is the difference between these two prices and what the broker charges you. This is how they make their money and stay in business. To illustrate, let’s say you want to make a long (buy) trade on the EUR/USD and your price chart shows a price of 1.2000.

The broker, however, will quote two prices, 1.2002 and 1.2000. When you click the buy button, you will be entered into a long position with a fill at 1.2002. This means that you have been charged 2 pips for the spread (the difference between the price 1.2002 and 1.2000).

Now say you want to make a short (sell) trade and again, the price chart shows a price of 1.2000. The broker will fill your trade at 1.2000, however, when you exit the trade – in other words buying back the short position – you will still pay the spread. This is because whatever the price shows at the time you want to exit your trade, you will be filled two pips above that price. For example, if you wanted to exit at 1.9980, you will in fact exit your trade at 1.9982.

The spread is the difference in the buy and sell price of any asset or currency pair. Therefore, the spread is a cost of trading to you and a way of paying the broker. The bid price is the highest price the broker will pay to purchase the instrument from you and the ask price is the lowest price the broker will pay to sell the instrument to you. In order for a trader to make a profit or avoid making a loss on a trade, the price must move enough to make up for the cost of the spread.

Variable rate spreads

It is also worth noting that the spread you pay can be dependent on market volatility and the currency pair that is traded. These variable spread fees are commonplace in markets where there is higher volatility. A spread you pay can be dependent on market volatility and the currency pairing that is traded.

For example, if a market is quiet, i.e. there is not much market activity and the volatility is low, the broker may charge a +2 pip spread. But if volatility increases or liquidity decreases, the broker/spread dealer may change that to incorporate the additional risk of the faster, thinner market and so they may increase the spread.

Some brokers also charge a commission for handling and executing the trade. In these circumstances the broker may only increase the spread by a fraction or not at all, because they make their money mainly from the commission.

What is commission and how is it calculated?

Commission in trading can either be a fixed fee – a fixed sum regardless of volume – or a relative fee – the higher the trading volume, the higher the commission. A commission is similar to the spread in that it is charged to the trader on every trade placed. The trade must then attain profit in order to cover the cost of the commission. Commissions can come in two main forms:

Fixed fee – using this model, the broker charges a fixed sum regardless of the size and volume of the trade being placed. For example: With a fixed fee, a broker may charge a $1 commission per executed transaction, regardless of the size involved.
Relative fee – the most common way for commission to be calculated. The amount a trader is charged is based on trade size; for example, the broker may charge “$x per $million in traded volume”. In other words, the higher the trading volume, the higher the cash value of the commissions being charged.

With a relative fee, a broker may charge $1 per $100,000 of a currency pairing that is bought or sold. If a trader buys $1,000,000 EURUSD, the broker receives $10 as a commission. If a trader buys $10,000,000 the broker receives $100 as a commission. Note: The relative fee is, in some cases, variable and based on the amount that is bought or sold.

For example, a broker may charge $1 commission per $1,000,000 of a currency pairing bought or sold up to a transaction limit of $10,000,000. If a trader buys $10,000,000 EURUSD, the broker receives $10 as a fee. However, if a trader buys more than $10,000,000 EURUSD, they will become subject to the new fee. Usually the commission is on a sliding scale to encourage larger trades, however, there are different permutations from broker to broker.

Additional fees to consider

There are also hidden fees with some brokerages. Some of the fees you should look out for include inactivity fees, monthly or quarterly minimums, margin costs and the fees associated with calling a broker on the phone. There are additional, hidden fees a trader should keep in mind, like inactivity fees, monthly or quarterly minimums, margin costs and fees associated with calling a broker on the phone.

Before making a judgement on which commission model is the most cost-effective, a trader must consider their own trading habits. For example, traders who trade at high volumes may prefer to pay only a fixed fee in order to keep costs down. While smaller traders, who trade relatively low volumes, may tend to prefer a commission based on trade size option as this results in smaller relative fees for their trading activity.

Overnight positions

When trades are held overnight there is another cost that should be factored in by the trader holding the position. This cost is mainly centred on the forex market and is called the overnight rollover. Every currency you buy and sell comes with its own overnight interest rate attached. The difference between the two interest rates of the currencies you are trading will give you the cost of holding the position overnight. These rates are not determined by your broker, but at the Interbank level.

These trading costs are percentage-based and would increase as the use of leverage goes up; the more leverage a trader uses, the higher these costs become. For example, if you buy the GBP/USD, then the rollover will depend on the difference between the interest rates of the UK and the USA.

If the UK had an interest rate of 5% and the USA had a rate of 4%, the trader would receive a payment of 1% on their position because they were buying the currency from the nation with the higher interest rate – if they were selling this currency, then they would be charged 1% instead.

Data feeds

Aside from the transactional costs of trading, extra costs should be factored in by traders when calculating their overall profitability. Data feeds help the trader see what is happening in the markets at any given time in the form of news and price action analysis.

This data is then used by the trader to make important decisions:

When to enter and exit the market
How to manage any open positions
Where to set stop losses

This data is therefore directly linked to the performance of the trader; good efficient data is vital in order to maintain a constant edge in the markets. Data feeds help a trader see what is happening in the markets in the form of news and price action analysis. Traders use this data to decide when to enter/exit the market, how to manage open positions and where to place their stop loss.

These costs are usually a fixed price charged monthly. The costs vary between providers, as does the quality and nature of their data feeds. It is important that traders determine which kind of feed they feel most comfortable and confident using before committing money to any feed provider. Other additional costs to a trader may include subscriptions to magazines or television packages, which enable access to non-stop financial news channels.

The cost of attending exhibitions, shows or tutorials may also need to be considered if you are a novice trader. Aside from this are the obvious necessary costs of owning a reliable PC or laptop, and cupboards stocked with plenty of coffee! Every trader needs a trading journal which can be made manually in excell or bought from available online tools.