Correlation & Money Management

twofingersRule 2: Never have more than 2 trades open at a time

This rule confuses a lot of new traders. They say, “Why not trade as much as you can so you’ll make more money?” It’s because of a little thing called correlation.

If two currency pairs are “correlated” it means that they tend to move together over time. A picture is worth a 1000 words, so let’s look at one now. The picture on the following page is of 5 different pairs over a 2 month period (Feb/March 2011). I have not altered them in any way, besides shrinking them so all 5 would fit on one page.

 

They look pretty similar, don’t they? That’s because they are highly correlated and tend to move together.

But how does this have an effect on our money management?

See that downwards spike about 1/3rd of the way in on all 5 pairs? What if you were in a long trade on each of those 5 pairs when that spike hit? Your stoploss would have probably been hit and you would have lost all 5 trades. 5 trades lost at 2% risk each means that ONE price spike caused you to have a 10% account loss!

That’s just unacceptable. Risking 2% each on 5 correlating pairs is the same as risking 10% on one trade. It’s just too dangerous, so we don’t do it.

Limit your trades to a maximum of 2 at a time and you’ll be safe. I usually limit mine to 1 trade at a time, but I will open 2 if I’m sure the trades aren’t correlated to closely.

That’s all there is to know about money management. All you have to do is risk 2% of your account on each trade, and never have more than 2 trades open at a time.

The real beauty of this money management plan is that you don’t have to worry about things like leverage, margin, drawdown, etc… Just follow the “2&2” rules, and you can safely ignore all those things!

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