Many new trades became surprised as they learn that controlling risk is nearly as important as making good trades in becoming profitable over the long term. Risk, money management, and position sizing are no less significant than trade entry and exit strategies. And people must consider all of these scientifically and thoroughly.
With that, as long as traders can maintain a trading hedge, they will have a solid blueprint for making much money. People do not need to have spectacular trades to be profitable; they just need to be consistent in doing the right thing and let the magic of compounded money management snowball the account equity’s growth.
The Money in Trading Account
People must consider the amount of cash they have, which is available for building wealth. And they should not include assets like a house or a car in that calculation. Once the number is on the table, traders can prepare to place not more than 10 to 15% of it into something risky, such as trading forex. Though this seems like a small amount, it is not.
The Amount to Risk per Trade
If traders have an idea of the average or median amount of profit they can reasonably expect to make on every trade, and they think of maximizing the total long-term profit – use a fixed fractional money management system based upon the Kelly Criteria.
Also, a fixed fractional system risks a similar percentage of the account value on every trade. Fixed fractional money management has two massive advantages over other strategies. First, people risk less in losing streaks and more during winning streaks – if the effect of compounding helps build up the account. Second, it is theoretically impossible to lose the full account, as traders are always risking X% of what is left, and never all of it.
In calculating the size of the fraction to risk, the Kelly Criteria is the formula for it. This was developed to show the maximum amount people can risk on a trade and maximize long-term profit. If traders know their approximate odds on every trade, they can calculate the optimal amount with the Kelly Criteria calculator. For good forex trading strategies, the amount suggested by the Kelly formula is usually in the range of 2% to 4% of account equity.
But here’s the warning, as traders use the full amount suggested by Kelly tends to huge drawdowns after losing streaks. Like Ed Thorp, several fine traders have recommended using half the amount indicated by a Kelly Criteria calculator. And this generates 75% of the long-term profit, but with only 50% drawdown, produced by the full Kelly Criteria.
Part of the Holy Grail
One of the major reasons traders fail even when they follow the trend and get their entries and exits mostly right is that they do not follow the risk and money management techniques set out as part of a comprehensive trading plan.
Don’t focus on the result of the trade made today. Instead, worry about the overall results of the next 200, 500, or 1000 trades. If trades can make a profit of only 20% of their risk on average per trade – which is feasible with a trend-following volatility breakout strategy -, it is likely to turn a few hundred into a million within ten years.