What makes money management so special? The fact that it can guarantee that you won’t lose all your money, that’s what!
Read that carefully… I said you won’t lose all your money. Forex is risky, and you could lose some money, but if you follow this money management plan and my trading method to the letter I can promise that no matter what type of disaster may befall you, you won’t lose all your money (or even most of it).
So what exactly is a money management plan? Think of it as an insurance policy on your Forex account. Why do you have insurance on your car, or on your life, or on your house? In case a disaster happens!
It’s the same with trading, you need protection from the ultimate Forex disaster… the losing streak!
Losing streaks happen, but most new traders underestimate them because they don’t understand how probability works. Just because you’re trading a method that has a 80% win rate does not mean that you will win 4 trades and lose 1 over and over in a repeating pattern. Losing streaks of 4, 5, and even 6 trades will happen. It’s not a matter of if it will happen, but a matter of when it will happen.
If you don’t believe me, just start flipping a coin. I bet you can’t get to 20 flips without hitting a streak of at least 4 heads or tails in a row. Your money management plan is an insurance policy against losing streaks like those. It keeps those streaks from wiping out your account.
“But Phil,” you say, “where do I get a solid money management plan?” Don’t worry, I’m going to give you one right now! I call it the “2&2″ money management plan…
Rule #2: Never have more than 2 trades open at a time.
It’s really is that simple, so let’s get started learning the 2&2 money management plan!
Yes, you will have to do some math before every trade, but it’s just basic multiplication and division, so don’t skip this section just because you hate math!
OK, let’s get on with the lesson…
Step 1: Account Balance x .02
Multiply your account balance by .02 to get the amount to risk on each trade.
Say we’ve opened a trading account with $1000 dollars and we want to place a trade on EUR/USD. We always want to risk 2% of our account on the trade, so we multiply our account balance by 2% ($1000 x .02) and get $20.
So the most we want to risk on this trade is $20. Now that we know the maximum amount that we can lose it’s time figure out what lot size gives us that amount of risk. The formula for that is easy…
Step 2: Amount to risk ÷ Stoploss
Divide the amount you want to risk by the stoploss (in pips) of your trade.
After we’ve planned our trade and know what our stoploss is going to be (we’ll learn how to do that later) we simply divide our risk by our stoploss. So if we want to risk $20 and our trade has a stoploss of, say, 50 pips, then we divide $20 by 50 pips and get 0.40 dollars per pip.
Now we know that we want our trade to have a value of .40 dollars (40 cents) per pip, but how many lots do we need to trade to get a value of 40 cents per pip? To find that out we’ll need to move on to step 3.
Step 3: The Value Per Pip We Want Our Trade To Have ÷ The Value of 1 Lot
Divide the value per pip you got in Step 2 by the value of 1 lot on your account type.
What is the value of 1 lot? That depends on the type of Forex account you have. The value per lot for all the different types of trading accounts are…
$10 per lot for a Standard Account
$1 per lot for a Mini Account
$0.10 per lot for a Micro Account
$0.01 per lot for a Nano Account
So if, for example, we have a micro account then 1 lot equals .10 dollars per pip. If we divide .40 dollars (the amount we want per pip) by .10 dollars (the value of 1 micro lot) we get 4, so we would need to trade 4 lots on this trade in order to risk 2% of our account.
Now I know there’s some Forex/math guru out there reading this saying, “Hold on, that’s wrong!! That formula depends on the pair you’re trading!”
That person is technically right, since not every currency pair is based on USD, but there’s no need to do the extra math to get “down to the penny” results. If you always use these three steps then, even with the margin of error, you’ll always be trading between 1.5% and 2.5%. This is still a safe percentage of your account, even if it’s not exactly 2%. The extra steps needed to get perfect results are more complicated, and will just confuse you and cause you to make mistakes.
OK, let’s work through one more example, just to be sure you’ve got the process down…
If your account balance is $13000 and you have a mini account, how many lots should you trade if you need an 80 pip stoploss?
Step 1: $13000 x .02 = $260 to risk
Step 2: $260 / 80 = $3.25 per pip
Step 3: $3.25 / $1 = 3.25 lots
So you would trade 3.25 lots on this trade. See, wasn’t that easy?