In this article, we would like to share some steps, developed during the years, for choosing the right Forex Money Management (MM) as part of your trading plan. There is no universal Money Management formula which will fit all types of trading strategies. So, we need a way to adapt to every type of automated trading system.
There are 4 core steps, to go through every time, as follows:
The first step is to make a long-term backtest of newly created strategy. The longer the time span, the better and the more valid the produced results are. One of the ways is to test your systems for more than 10 years time span. If it is long-term based on daily or weekly bars, then it might be better to use 20-30 years of data to produce a significant amount of trades. When you have such a long-term prospective you could rely more (not 100%), that in the future you won’t experience a big surprise, because of a unique market behavior. It doesn’t matter which trading platform one uses at this step. All of them will produce the data you need for the second step.
A way to generate a detailed statement from your trading platform is via excel by converting every trade into R-multiple. You can divide the trade`s gain by the amount of its initial Stop Loss. So if a particular trade has gained 150 pips and its SL is 120 pips, then it is 150/120 = 1.25 R.
The conversion is done for the equalization every market. Every trade has equal weight and across to different market cycles with changing volatility to treat trades equally. So, with this ratio you could compare 10 points gain in Gold with 120 pips on the EUR/USD and 50 pips during quiet market to 200 pips gain during wild juncture.
Equity Curve in R and MaxDD
The next step is to make an accumulated chart using R-multiple ratios. It will look like this:
There isn`t any special calculation at this stage, just simple accumulative math formula.
Based on the chart above, you calculate the MaxDD, which is measured from peak-to through. MaxDD is the biggest equity drop for the entire period of backtesting. So you have to prepare yourself emotionally to face at least as big as MaxDD account decline during the real time trading. So, in terms of Forex Money Management it is the most important information a trader could extract from the past performance.
Choosing Your Forex Money Management System
Once we have all information we need, it is time to ask ourselves few questions:
- How much risk we are willing to put on this particular trading system?
- How much equity drop we could tolerate without being burned out emotionally?
Of course, the answers to these question depend on the trader`s capital, personality, and objectives.
For example, if you have a system with MaxDD of 40 R and you plan to be very conservative because, you will trade for your retirement, and you intend to put big money into it, then you could set my max. risk at 10%. So, you should limit your risk per trade to 0.25%. By doing so, you know that your MaxDD will be around 10%. The calculation is done as follows – take your desired risk and then divide it to MaxDD taken from the backtest in R and you will get the risk you have to put per trade. In the occasion it is 10/40=0.25%
On the other hand, if you are willing to be aggressive with the same strategy, by showing willingness to risk as much as 40% of your capital, then putting 1% on every single trade would make sense for your objective. The calculation here is 40/40=1%.
We have presented to you a way to determine your Forex Money Management as part of a trading plan. If you prepare enough with your risk per trade, it is most likely to avoid any big surprises, which could potentially lead to trading mistakes and losing money in the future. Of course, we have to reiterate that past performance isn’t an absolute indicator for the future and it is likely the MaxDD to be greater during real trading.
We hope that we have contributed to your knowledge regarding the matter. We wish you a profitable trading.