1. Money Management

Money management is the most important aspect of trading. Having a sound money management system will make a huge difference in your profits. It will help improve your performance and minimize your losses.

Money management is what can separate you from going broke to becoming a successful trader. Many traders do not realize there is not always a reward in the market but there is ALWAYS risk. Although profits cannot be predicted, the only factor you can control is risk.

Money management basically deals with 3 elements:

Choosing the size of your position (position sizing is the calculation of how many lots you should hold in a position).
Damage control (this is the amount to risk in each trade (in GBP).
Setting your stop loss in pips away from your entry level.

Maximum Drawdown

The term drawdown means that your capital is reduced due to losing trades. The more you lose in your account, the harder it is to make it back. Therefore you should only risk a small percentage of your account in each trade, with a maximum of 3%. Drawdowns on your account are part of trading but if you establish a trading plan then it will enable you to survive these losses and not wipe out your account. To calculate the drawdown you would usually take the difference between the highest equity value in your account at one time minus the lowest. It is then usually represented as a percentage of your trading account.

Below you can see an example that shows what percentage you would have to make to break even if you were to lose a certain percentage of your account.

Loss of capital % Required to get back to breaking even

5% 5.26%

10% 11.11%

15% 17.65%

20% 25%

25% 33%

30% 43%

40% 67%

50% 100%

60% 150%

70% 233%

80% 400%

90% 900%

You can see that the more you lose, the harder it is to make it back to your original account size. This is the reason that you should do everything you can to protect your account. Therefore, it is best that you only risk a small percentage of your account in each trade so that you can survive your losing streaks and also to avoid a large drawdown in your account.

Stop Loss

Many people trade without any system that manages their risk. They trade without using a stop loss. A famous professional stock trader by the name of Alexander Elder described trading as being like a high-wire act. In his book entitled Trading for a Living, Elder said You may walk the wire a hundred times without a safety net but the first fall can kill you.

However, you cannot afford to take that chance. You can have a system that is 99% accurate and lose money. You can also have a system that is 1% accurate and make money. Which one do you choose?

How Much to Risk and When to Stop Trading

The key element of money management is not to be greedy! Before you start trading you have to establish how much you are willing to risk losing in one year, and if you do lose money you have to know when to stop trading so you do not lose more than planned.

Below is an example that shows when you should stop trading based on how much you lose and in what time period.

Amount to Risk in 1 Year: £9,000

Monthly Stop LossLose: £3,000/month

Daily Stop LossLose: £1,000/day

Stop Loss per tradeLose: £300/trade

If you lose £9,000 during the year, stop trading for the rest of the year.
If you lose £3,000 during the month, stop trading for the rest of the month.
If you lose £1,000 during the day stop trading for the rest of the day.
Set your Stop loss to £300 per trade.

Risk-Reward Ratio

Once you have established how much of your capital to risk, it is also good money management to have a reasonable risk to reward ratio per trade. The risk to reward ratio shows how much money you are risking versus the potential reward (or profit) on a trade. While this may seem simplistic, many traders neglect taking this step and often find that they end up with large losses.

A good risk to reward ratio, especially for new traders is 1:3. Any number below 1:2 is too risky. It is best not to enter a trade in which the risk reward ratio is 1:1 or the risk outweighs the reward. There is very little room for smaller price movements and the amount of risk will increase.

Have a look at few examples of risk to reward ratio:

If the risk is £200 and the reward is £400, then the risk-reward ratio is 1:2 (calculated by 200:400)
If the risk is £500 and the reward it £1,500, then the risk-reward ratio is 1:3 (500:1500)
If the risk is £1,000 and the reward is £500, then the risk-reward ratio is 2:1 (or 1000:500)

Now set’s assume you are trading EURUSD. You enter at a price of £1.3000 and you want make a profit of 45 pips so you set your exit level (profit target) at £1.3045. You set your stop loss at £1.2985. This is 15 pips below your entry level. This means your risk to reward ratio is 1:3. You are risking 15 pips for a chance to gain 45 pips.

Position Sizing (Number of Lots)

Choosing the right number of lots will improve your risk-return ratio. In forex trading, position sizing is particularly important since leverage is involved. If you trade too many lots, a string of losses could force you to stop trading. On the other hand, if your position is too small, much of your account equity will sit idle, which will hurt your performance. Finding the right balance is the key to risk management.

Calculating the Size of Your Position

First set the amount you want to risk per trade e.g. GBP 1,000.
Find the entry level (price). Suppose your system gives you a signal to Buy EURUSD at 1.2950.
Determine your stop loss level. This will usually be a few pips below the support level e.g. 1.2900.
Use this to calculate the number of pips between the entry and exit levels of your trade. 1.2950 – 1.2900 = 0.0050.
The question you have to ask now is: If you put your stop loss 50 pips away how much do you risk for every lot in EURUSD? Since 1 lot is 100,000 base units, 100,000 * 0.0050 = GBP 500.
Finally divide your stop loss amount (£1,000) with this number to give you the amount to trade 1,000 / 500 = 2 lots.

Calculating the Amount to Trade

Stop Loss Per Trade: £1,000

Entry Level: £1.2950

Stop Loss level: £1.2900

Stop Loss in pips: 1.2950 – 1.2900 = 0.0050

Amount to risk per lot: 100,000 * 0.0050 = $500

Amount to Trade: £1,000 / $ 500 = 2 lots

Martingale or Anti-Martingale

Different day traders have developed many different ways to manage their money. Some base their trading strategy on different statistical probability theories, and some base it on strategies used in casino gambling. Such are the Martingale and anti-Martingale strategies.

In the Martingale method, you decrease the amount of risk after you win a trade and you increase the amount after a loss. The simplest of Martingale strategies was designed for a game in which the gambler wins his stake if a coin comes up heads and loses it if the coin comes up tails. The strategy had the gambler double his bet after every loss, so the first win would recover all previous losses plus win a profit equal to the original stake. Since a gambler with infinite wealth would eventually flip heads, the Martingale betting strategy was seen as a sure thing by those who advocated it. Of course none of the gamblers in fact possessed infinite wealth and the exponential growth of bets would eventually bankrupt those who chose to use the Martingale. Stay away from Martingale strategies!

The alternative method is known as the anti-Martingale method. You increase the number of lots as your profits increase and you decrease the number of lots as your equity drops during a drawdown. When you make a profit it means that the market is trending so increase the amount of your trades to follow the trend.

2. Trading Psychology

An essential component of successful trading is psychology. By the term psychology we refer to the state of mind a trader should have while trading. More specifically, trader psychology deals with:

Control of trader’s fear
Control of trader’s greed
Trader’s discipline.

Why We Trade

Trading is a highly exciting activity. The trouble is that it is hardly possible to feel excited and make money at the same time! Think of a casino where amateurs celebrate over free drinks, while professional card counters coldly play game after game, folding most of the time and pressing their advantage when the card count gives them a slight edge over the house.To be a successful trader, you have to develop iron discipline.

Psychological Trading Issues and Their Causes

Fear of being stopped out or fear of taking a loss: the usual reason for this is that the trader fears failure and feels that he can’t take another loss. The trader’s ego is at stake.

Getting out of trades too early: relieving anxiety by closing a position. Fear of position reversal and as a result, feeling let down. Need for instant gratification.

Adding on to a losing position (averaging down): unwilling to admit your trade is wrong and hoping that it will come back. Again, the ego is at stake.

Wishing and hoping: not wanting to take control or responsibility for the trade. Inability to accept the current market situation.

Compulsive trading: drawn to the excitement of the markets. Presence of addiction and gambling issues. Needing to feel you are in the game.

Excessive joy after a winning trade: relating your self-worth to the markets. Feeling unrealistically “in control” of the markets.

Limiting profits: feeling that you don’t deserve to be successful, to have money, or to make profits. Usually, psychological issues such as poor self-esteem.

Not following your proven trading system: you don’t really believe it works. You did not test it well. It doesn’t match your personality. You want more excitement in trading. You don’t trust your ability to choose a successful system.

Over-thinking your trade, second-guessing your trading signals: fear of loss or being wrong. Wanting a sure thing where sure things don’t exist. Not understanding the fact that loss is part of trading and the outcome of each trade is unknown. Not accepting the fact that trading imposes risks. Not accepting the unknown.

Not trading the correct position size: dreaming that the trade will only be profitable. Not fully recognizing the risk and not understanding the importance of money management. Refusing to take responsibility for managing your risk.

Trading in excess: need to conquer the market. Greed. Trying to get even with the market for a previous loss. The excitement of trading (similar to compulsive trading).

Being afraid to trade: no trading system in place. Not comfortable with risk and the unknown. Fear of total loss. Fear of ridicule. Need for control.

Irritable after the trading day: emotional roller coaster caused by anger, fear, and greed. Giving too much attention to trading results and not enough attention to the process itself and to learning the skills of trading. Focusing too much on money. Unrealistic trading expectations.

When trading with money you can’t afford to lose, or trading with borrowed money: last hope for success. Trying to be successful at something. Fear of losing your chance for the opportunity. No discipline. Greed. Desperation.

These are by no means all the psychological issues – but they are the most common. They usually center on the fact that, for one reason or another, the trader is not following his chosen trading approach or system but wings it, or trades his own emotions, which is a no go. As you see, psychology in trading is vital.

In terms of psychology, your goal is to be on an even keel, so to speak. Your winning and losing trades should not affect you. Of course, we all trade better when we win, but we should strive to maintain an emotional balance regardless of any gains or losses.

Accepting Loss

The first reason why traders lose may seem obvious, but in reality it stems from long-term social conditioning: the inability to accept loss. Loss generates powerful emotions such as fear, uncertainty, apprehension, and self-doubt, especially with men.

Men are socially conditioned to succeed from the moment they enter the world. They are brought up to become achievers. Influenced by family, friends, education, and career environment, they are encouraged to seek professions as doctors, lawyers, and bankers. Striving to be right, number one, the breadwinner, and the best, always seeking perfectionism. Men are socially conditioned to be family providers. Moreover, various cultural pressures and demands add up to this, and as a result men have an intrinsic fundamental obligation to succeed.

The solution is to take a reality check. Losing is part of the game. The possibility to lose is always there. Bottom line: traders do lose. The how much and how often is what distinguishes great traders from those who will always struggle.

You can learn how to accept losses by re-defining the meaning of loss. If you equate it with failure, it will sooner or later take its toll, but re-defining it will help you move forward, improve your trades and cope with possible losses. Consider losing as positive in the sense that it will improve your next trades. Find something new. Make the mistake a blip on the radar, don’t over-react, and let it come and go with ease.

Locked Patterns

The second most important trading challenge is the innate human characteristic of patterns.

Here is an example of a trader with a locked-in pattern:

He keeps making the same mistake when trading. When asked to describe the mistake, he will do so in detail. When he is told not to repeat the same mistake again, he says he can’t help it. Although he intellectually knows he should stop making the mistake, he can’t. He keeps repeating it and as a result, repeats his losses over and over again, too.

You go long and the market immediately goes down.
You go short and the market immediately goes up.
You start shaking, sweating, get short of breath.
You are ready to throw your computer out the window and jump out yourself.
And the market has only been open for 30 minutes.
What is going on?
You are in a trading psychology spiral.

Breaking a Pattern

Getting up and moving is the fastest way to stop a pattern.

Go for a walk and come back.
Check if you followed your system.
See if your system needs any improvements and apply them.
Stick with your system and accept that days like this do happen.
Trade smaller amounts until you make profits again.
It’s important to avoid bad patterns at any cost. Do whatever it takes to break them.

How to Break a Pattern?

It is critical to notice when the pattern is happening and to never let it take hold. Dealing with the loss immediately will help you to achieve this.If you have 3 trades that look exactly alike and they are all losing trades, it’s imperative that you make it a must to examine them and change your approach. If you don’t, the probability of repeating it and losing again is extremely high. And above all, never forget that a trader must do whatever it takes to stop.

Blocked Emotions

Finally, the biggest and most dangerous of the three problems is emotion. When a trader gets over-emotional about a trade at anytime, he can’t think clearly because emotions take control over his common sense. Emotions will cloud judgment, block clear thinking, and therefore prevent the trader from being creative. To sum up, emotions override logical thinking. This is how you know you’re having an emotional block: you want to trade and also react in a certain way but you simply can’t, and even though you intellectually know what you want to do, you tend to react differently.

Locked Emotions

Our emotional strengths and peak mindset are shaped by how and what we think. If we generate bad thoughts, they will affect the overall thinking process – but if we input positive thoughts, the output will also be good. The best way to exclude emotions is to ask the mind a good question. Such questions force the mind to release emotion, as it shifts to finding the answer to that particular question. Also remember this: should you not be able to control what you are doing, the onset of a strong emotional block is likely. In such cases, you will need additional help to release it.

Reminiscences of a Stock Operator (1923)

In trading, your biggest enemy is within yourself. Success will only come when you have learned to control your emotions. Edwin Lefèvre’s Reminiscences of a Stock Operator (1923) offers advice that applies even today.

Human nature being what it is, most traders and investors ignore these rules when they start out for the first time. It can be an expensive lesson, though.

Control your emotions and avoid being swept along with the crowd. Make consistent decisions based on sound technical analysis.

Caution: Excitement, along with the fear of missing an opportunity, often drives us to enter the market before it is safe to do so. After a down trend a number of rallies may fail before we can carry eventually carry it through. Likewise, the emotional high of a profitable trade may blind us to see the trend reversal.

Patience: Before you trade, wait for the right market conditions. At times, it is wise to stay out of the markets and observe it from the sidelines.

Conviction: Have the courage to cling to your convictions. Take steps to protect your profits when you see that a trend is weakening, but sit tight and don’t let the fear of losing some of your profits cloud your judgment. There is a good chance the trend will resume its upward climb.

Detachment: Concentrate on the technical aspects rather than the money. If your trades are technically correct, the profits will follow. Stay emotionally detached from the market. Avoid getting caught up in short-term excitement. Screen watching is a tell-tale sign: if you keep checking the prices or stare at charts for hours, it’s a clear sign of insecurity about your strategy and you are likely to suffer losses.

Focus: Focus on the longer time frames and don’t try to catch every short-term fluctuation. The most profitable trades are in catching the large trends.

Expect the unexpected: Investing involves dealing with probabilities, not certainties. No one can predict the market correctly all the time. Avoid the gambler’s logic.

Average up, not down: If you increase your position when the price goes against you, you are likely to compound your losses. When the price starts to move, it tends to keep moving in that direction. Increase your exposure when the market proves you right and moves in your favor.

Minimize your losses: Use stop-losses to protect your funds. Once the stop-loss is set, don’t hesitate but act immediately. The biggest mistake you can make is to hold on to a losing position and hope for recovery. The markets have a habit of declining way below what you anticipate. Eventually, you are forced to sell, decimating your capital.

Be Cool

Markets change, new opportunities arise and the old ones fade away. Good traders are professional but humble people – this is why they keep learning. Speculators get paid for buying what nobody wants, when nobody wants it, and selling what everybody wants, when everybody wants it. Remember that there is no such thing as a bad trader. On the contrary, there’s only well-trained traders or badly trained traders.

Conclusion

You will be more successful when you learn to control your emotions. These are strong words of advice first offered by trader Edwin Lefevre in his book entitled Reminiscences of a Stock Operator in 1923. This book is well worth a read to any trader.

Be cautious, be cool and be patient! Wait for the right conditions in the market before entering it. Sit tight when you are losing, do not let fear grip you, have courage in your convictions. Detach yourself from your emotions at that point and focus on your trading system. It would also help if you detach yourself from your computer screen! If you have placed your stop loss it is not necessary to be constantly watching the screen! This means that you are unsure of yourself.

Don’t be afraid to let go of a losing position. Do not add to a losing position! It is best to average up not down. So add on winning positions instead of on losing ones! New opportunities will always arise.

The bottom line is that having the right attitude and the right mindset will make you more successful in trading!

1. Money Management

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