By Danny Vescio If you've been following my blog, you should realize by now that money management (A.K.A. risk management, position sizing) is what makes all the difference in the world when it comes to your bottom line. Forex traders definitely don't realize that when starting out.
The purpose of this article is to show you just how much of an impact it actually has and how it can take an already profitable forex trading system to exponentially new profit heights. And the only way I know how to demonstrate this beyond a shadow of a doubt is with an example of a money management strategy known as "scaling in"
Scaling into to your positions simply means that you continue to add contracts to your position as the market moves in your intended direction. And you will soon see the incredible power of this technique.
Now let's assume that you are using a trading strategy that attempts to catch large-scale price movements (trend-following) and your system dictates that you go long (buy) EUR/USD. Let's further assume that you will initiate your position with 1 mini contract. Since you are trend-following your goal here will be to hold the trade as long as momentum is in your favor. As soon as the market shows you evidence that momentum has died out you exit the trade (i.e. could be based on any one of several things such as support/resistance, indicators, candlestick signal, trailing stop, etc)
For the record, as subjective as I might have made the above set-up sound, it was done that way for simplicity's sake. Your entry and exit rules MUST be specifically known and tested ahead of time.
Let's get some easy-to-understand numbers on this:
You enter the market at 1.5000 and place an initial stop loss at 1.4900 (100 pip stop). You've entered with 1 mini contract and will add an additional one every time the market moves another 100 pips higher.
Now I realize this would be easier to understand with a chart, but just humor me here. Price movement develops into a nice up-trend and over the next 2 months you see the pair rise all the way up to 1.5990 before losing momentum and dropping. Your exit rules got you out of the trade at 1.5750.
Let's add this up. Since the pair rose all the way up to 1.5990 this means you would have accumulated a total of 10 mini lots on this position along the way, with your last 2 entries at 1.5800 and 1.5900 losing money. Your first 8 entries made you money.
Your profit? Thought you'd never ask! Your first contract was entered at 1.5000, so this made 750 pips (1.5750 - 1.5000). Your second contract was entered at 1.5100 so this made you 650 pips (1.5750 - 1.5100) and so on. Calculate the final value of all participating contracts and you will see that you made a combined 3000 pips, which equates to a sweet $3000.00 of profit (each pip is worth $1.00)
Compare the result of this strategy to the result of simply holding your first contract and not adding any more. We're talking $3000.00 vs. $750 of profit, respectively. That's an insane difference!!! A reward:risk ratio of 30:1 compared to 7.5:1. This is the power of a money management plan and scaling in.
Hold on, though! I know I've painted quite a rosy picture here but you should be aware of the pitfalls to such an approach: It's risky, mainly from a psychological perspective.
Most human beings are wired to want to be right most of the time. With this approach you will be wrong far more often than you are right. So you need to be able to stomach many consecutive losses.
The reason is that this approach generally works best when sustained trends take place with relatively minor retracements. These kinds of uninterrupted trends do not occur very frequently in the market place (although we've had some lately) so you will get whipsawed in an out of trades many times.
The most legendary traders made millions using such a method because even after losing many many trades, they ultimately had the patience and discipline to keep at it until that single winning trade made up for all the losses many times over.
Most don't have that degree of patience and so most will not trade in such a way.
If you feel you do have the patience, then this approach may be just what you need to take your trading career to the next level. The insanely high reward to risk makes it worth your while to at least ponder the concept.
Check out the money management posts of my blog to read more and see some free videos about it.
Danny Vescio is an active currency trader and internet marketing enthusiast. He enjoys writing about a variety of topics but his passion is the currency market and passing on his knowledge of currency trading to newer traders. Visit his comprehensive blog at http://wannatradecurrency.blogspot.com to learn what it really takes to become successful trading forex. Topics are organized chronologically to make your learning curve as seamless and focused as possible. |
