This is a fundamental matter because funds management directly concerns the success or failure of trading.
I. Basics of Funds Management
Why is funds management so important? Because we are engaged in a profit-making business. We must learn how to manage funds. But most traders ignore this aspect of trading.
Strangely, many forex traders rush into trading without considering their account size or the reasonable amount of funds to use. They simply press the trade button without hesitation.
Trading behavior without a strategy and the concept of funds management cannot achieve long-term investment returns. funds management not only protects us, but in the long run, it also improves our profit level.
If you are a genius in probability, then in the long run, you will be the ultimate winner.
II. Drawdown Rate and Maximum Drawdown Rate
Although we already know that funds management will help us in the long run, now we want to show you another aspect: what happens if you use the rules of funds management?
Consider the following example:
Suppose you have $100,000 and you lose $50,000 of it, what percentage of the entire account is your loss? The answer is 50%. A very simple question. Now, how much percentage do you need to increase to get back to the original $100,000? It’s not 50% now; you need to increase by 100% to get back to the previous $100,000. In this example, the lost $50,000 is the loss amount, which is a drawdown rate of 50%.
Even if you have an excellent trading system, please consider the following example:
In trading, we are always looking for an advantage. This is also the main reason why forex traders are committed to developing trading systems. A trading system with a win rate of up to 70% sounds very good, a great advantage.
However, if your trading system has a win rate of 70%, it means that you will have 30 losing trades out of every 100 trades, so is it possible to have 7 to 10 consecutive losses?
It’s not impossible! How do you know which 70 trades out of 100 will be profitable? You cannot determine their distribution.
You may lose in the first 30 trades and then profit in the next 70 trades. We have seen 99 consecutive trades without loss, and to round up to 100, forex traders are severely trapped until they finally blow up their accounts.
This is why funds management is so important. No matter what system you use, if you don’t rely on funds management, you may ultimately fail.
Only when the risks you take are within the allowable range of your account can you be screened by the forex market, and the market ensures the evolution of excellent traders through natural selection. Remember: if you strictly implement the rules of funds management, then you will become the winner of natural selection; you can win!
Now let’s see what happens if you adopt proper funds management methods, and what happens if you don’t.
III. Don't Lose Your Ability to Recover
If you risk 2% of your account funds versus 10% of the funds, it has an extremely different impact on the trading outcome. If the risk capital ratio is 10%, when you happen to experience 19 consecutive trading mistakes, your funds will drop from $20,000 to only $3,002, then you will lose 85% of your account funds!
However, if the risk capital ratio is 2%, your account will still have $13,903 left after the above losses, which means you only lose about 30% of the funds.
Of course, if the number of consecutive losses is 5 instead of 19, what will be different? If the risk capital accounts for 2% of the total capital, then after 5 consecutive losses, there will still be $18,447 left; if the risk capital accounts for 10% of the total capital, then after 5 consecutive losses, there will still be $13,122 left, which is much better than the situation of 19 consecutive losses.
The purpose of these examples is to tell you to manage your funds well so that you can still play after a period of losses. Can you believe what your account looks like after losing 85%? You must increase by 566% to return to your initial capital level. I believe you do not want to be in this situation.
The more you lose, the greater the effort you need to make to return to your original capital, which also means the greater the difficulty you face. This is one of the reasons why you need to make a great effort to protect your capital.
You must control the number of capitals at risk so that you can still have the strength to win the final victory after experiencing consecutive defeats.
IV. Risk to Reward Ratio
Another way to increase your profits is to enter trades when the potential reward-to-risk ratio is greater than 3:1. If you can find trading opportunities with a reward-to-risk ratio greater than 3:1, you will have a significant advantage in trading.
In this example, you can see that even if your win rate is 50%, you can still make a profit of $10,000. It’s important to remember that whenever you trade, you need to achieve a good risk-to-reward ratio, which will significantly improve your trading advantage, even if you have a lower win rate.
V. Pyramid Positioning
Pyramid positioning is a widely known but seldom used position and funds management method, especially among many forex beginners who may have never used the pyramid approach to increase their positions.
This position management method was first advocated by the speculative master J.L. Let’s discuss the basic rules and specific applications of this position management strategy.
1. Basic Principles of Pyramid Positioning
The first principle is that you must only increase your position when the existing position is profitable. This rule ensures that you do not increase your position against the trend, as it is human nature to do so, and we must adhere to this principle.
Of course, there is an exception for those who plan to establish the remaining positions during a pullback or rebound, which is fundamentally different from increasing positions against the market: first, it is planned; second, there are strict risk control requirements for replenishing positions.
The second principle is to adhere to a decreasing position size when increasing positions. That is, each time you increase your position, the size should not be larger than the previous position. This is where the name “pyramid” comes from.
The third principle is to control the number of times you increase your position based on the length of the trading wave. In most cases, the number of consecutive increases should not exceed three. In extreme range markets, all positions are established at the time of opening; in extreme trend forex markets, most positions are added later. That is, in extreme oscillating markets, the number of increases tends to be zero, while in perpetual trend markets, the number of increases tends to infinity.
2. Common Types of Pyramid Positioning
Below are some common pyramid position ratio distributions. The ratio you use should be determined based on market conditions and your personal trading style.
The general principle is that the larger the trading time frame, the more inclined you are to the number and frequency of later positions; the smaller the trading time frame, the more inclined you are to the initial position size; the stronger the forex market trend, the more inclined you are to the number of later positions, and the weaker the market trend, the more inclined you are to the initial position size.
In trend markets, the more the market runs, the more it demonstrates the strength of the trend, and the greater the probability of continuing in that direction, so our position should increase; in range markets, the more the market runs, the closer it is to a turning point, and the smaller the probability of continuing in that direction, so our position should gradually decrease.
Increase positions with the market in trend markets, and decrease positions with the forex market in range markets. Below are the position ratios in trend markets:
5 3 2
5 3 1 1
5 4 1
5 2 2 1
4 3 2 1
4 4 2
4 3 3
4 2 2 2
4 3 1 1 1
4 2 2 1 1
3 2 2 1 1
3 2 1 1 1
3 1 1 1 1
2 1 1 1 1
The above numbers represent the size of the position, for example, 5 represents 50% of the position. If the first trade is profitable after opening, you may consider increasing your position at the pullback point for the first time, and the position size of the first increase must be smaller than the initial opening position.
The method for subsequent increases is the same, remember “you should increase at the pullback point, and only when all open trades are fully profitable,” but it is allowed for the position size after the first increase to be equal to the previous increases, but not larger. Generally, do not chase high prices when increasing positions, as this generally carries a greater risk.
3. Benefits of Pyramid Opening and Positioning
The most important function of this operation method is to effectively avoid losses. For example, if you find the forex market reversing after the first increase, you should clear all positions before the middle price between the first opening price and the first increase price at the latest. Since it is pyramid positioning, such operations are always profitable.
You can temporarily retain the first opening trade and the first increase trade, which allows you to continue observing forex market developments, making it easier to continue decreasing or increasing positions later.
The inverted pyramid shows the irrational side of humanity. Traders may not be very optimistic about the forex market when they first open positions, so the position size is relatively small, but the market develops unexpectedly, resulting in high emotions. Under high emotions, forex traders often forget to choose the stop-loss point first and control the position size under the 8% stop-loss principle.
Once the forex market slightly retraces, it often causes losses, turning profitable trades into losing ones. Therefore, we believe that if this situation occurs, the first increase can be considered an independent opening action, isolated from the original opening trade for independent operation. Following the normal process discussed earlier, before entering the forex market, you still need to find a good stop-loss point and adhere to the 8% stop-loss principle for position control.
In addition to the pyramid, there is also a practical equivalent positioning method. The quantity of openings and each increase is the same. Using this method, you do not need to consider the 8% loss issue when increasing positions. The thinking is the same as pyramid positioning; when the increase in trade retraces to before half of the previous trade, you should clear the positions, otherwise, you will face losses.
VI. Common Funds Management Techniques
1. Techniques for Matching Margin and Position Size
Before discussing this, let’s correct a misconception about margin trading. Many believe that margin trading is riskier than spot forex trading, which I think is a misunderstanding. This notion equates the leverage ratio in margin trading with the actual risk coefficient of trading, which is a biased understanding.
A forex broker offering 200 times capital leverage does not mean that the investor is taking on 20 times the investment risk. The leverage ratio and trading risk are not directly related; what’s linked to trading risk is the amount of margin in the investor’s trading account and the number of positions opened.
For example, a forex broker offers mini and standard margin accounts: the minimum opening size for a mini account is $10,000, where a 1 pip movement risks $1; for a standard account, the minimum opening size is $100,000, where a 1 pip movement risks $10.
Why is the risk for a mini account smaller than that for a standard account, despite the same 100 times leverage? The reason lies in the size of the positions opened. The larger the position size, the greater the risk to the account, which I believe even elementary students can understand. Yet, some friends who trade spot forex insist that margin forex is riskier than spot forex, which is quite puzzling.
Many newcomers to forex margin trading often ask “Where is it better to open an account, what is the appropriate leverage ratio?” My usual response is “Where to open an account and how much leverage is not the most critical, the risk of investment mainly comes from yourself.” Effective risk control is learning self-control. Back to the main topic, how to match your margin with your position size, our suggestions are:
(1) If the margin is below $500, do not exceed 10,000 in position size;
(2) If the margin is below $5,000, do not exceed 500,000 in position size;
(3) If the margin is below $10,000, do not exceed 1,000,000 in position size.
2. Common Forex Trading funds Management Techniques
First, the funds management technique of trading at key levels.
The difficulty in establishing long positions near important support levels:
(1) Determining the strength of that support level;
(2) Strictly buying at the support level can miss opportunities;
(3) Buying in advance often results in a high price, disrupting the risk-reward ratio, and making it difficult to set stop-losses.
Countermeasures:
(1) If the support level is strong, enter the forex market in advance;
(2) If the support level is moderate, enter the forex market in batches near the support level, stop loss if it falls below the support level by a certain extent, and increase your position when the price rebounds from near the support level, but the position size for higher level increases should be lighter (i.e., pyramid principle);
(3) If the support level is weak, continue to observe.
The technique for establishing short positions near important resistance levels is the reverse operation, with the same principle.
Second, the funds management technique of trading on breakouts.
The technique for establishing long positions when the exchange rate breaks above important resistance levels:
(1) Determine the strength of that resistance level and the probability of a breakout before it happens.
(2) If the probability is high, consider entering the forex market in batches.
20% of the capital enters before breaking the resistance level;
20% of the capital enters after breaking the resistance level by a certain extent (according to the principle of effective breakout space);
30% of the capital enters when the pullback confirms after breaking the resistance level;
30% of the capital continuously increases positions according to the pyramid principle as the exchange rate rises.
(3) If the probability of a breakout is low, choose to observe and wait to enter after the breakout.
30% of the capital buys after the breakout;
40% of the capital buys after a pullback and turns upwards again;
30% of the capital increases positions according to the pyramid principle after the uptrend is confirmed.
The technique for establishing short positions when the exchange rate breaks below important support levels is the reverse operation, with the same principle.
Third, the technique for closing long positions near important resistance levels.
Difficulties:
(1) Determining whether it’s a trending or ranging forex market;
(2) Closing positions too early prevents maximizing profits;
(3) Closing positions close to important resistance can miss opportunities.
Countermeasures:
(1) If the resistance is weak, the probability of a breakout is relatively high, and the forex market is in a trending market.
Close to 10% near the resistance level;
Close to 30% near the resistance level;
Set a stop-loss at a certain distance below the resistance level, close to 60% if the price falls and reaches the stop-loss price;
If the stop-loss price is not reached, and the resistance is broken, forming an effective breakout, then according to the technique of building positions on breaking resistance, the already closed 40% will be replenished opportunistically.
(2) If the resistance level is strong, and the forex market is in a ranging market.
Close to 30% near the resistance level;
Close to 40% at the resistance level;
Set a stop-loss at a certain distance below the resistance level, close to 30% if the price falls and reaches the stop-loss price;
If the stop-loss price is not reached, and the resistance is broken, forming an effective breakout, then according to the technique of building positions on breaking resistance, the already closed 40% will be replenished opportunistically.
The technique for closing short positions near important support levels is the opposite operation direction, with consistent principles.
Fourth, the technique for setting stop-losses.
(1) Determine the market characteristics, whether it’s a trending or ranging forex market.
(2) A good stop-loss price is predicated on a good opening price.
(3) In a trending market, operations that go with the trend can have a moderately relaxed stop-loss, but it’s best to intervene in the trend during pullbacks and rebounds, that is, using the multi-timeframe trading guidance we mentioned.
(4) In a ranging forex market, the stop-loss range for positions can be relaxed, such as during the Asian market when no important news is released.
VII. Eight Standards for Setting Reasonable Stop-Losses
Understanding the importance of stop-loss is only the first step. Specific steps for stop-loss include setting it reasonably and executing it effectively. The reasonable setting of stop-loss must rely on probability management tools and funds management principles. There are several methods for setting stop-loss, which need to be used reasonably:
(1) Fixed loss ratio method. Set according to the degree of loss, usually, the stop-loss for speculative short-term buying is set at a 2%~8% drop, while the stop-loss for investment-type long-term buying is set at a relatively larger drop percentage.
(2) Volatility range stop-loss method. Sell when the exchange rate drops from the highest price of the wave by a certain extent compared to the highest price of the wave. If the investor is at a loss at this time, it’s called a stop-loss; if in a profit state, it’s called a stop-win. This method is mostly used for stop-win in most cases. How much the drop percentage should be set for stop-win depends on the activity of the currency, more active currencies should have a larger range.
(3) Technical indicator stop-loss method. Set according to the support level of technical indicators, mainly:
Moving average indicators, such as the 8-period moving average, 13-period moving average, etc.
Bollinger Bands indicator. In an uptrend, the exchange rate crosses below the upper band of Bollinger Bands; in a downtrend, the exchange rate crosses above the lower band of Bollinger Bands.
Parabolic SAR indicator. For long positions, when the parabolic SAR indicator breaks below the turning point; for short positions, when the parabolic SAR indicator breaks above the turning point.
(4) Set based on key positions of significant importance.
(5) Set reference points based on candlestick patterns, mainly:
The tangent of the trend line;
The neckline of the head and shoulders or rounded top and bottom and other head formations;
The lower rail of the ascending channel, the upper rail of the descending channel;
The edge of the gap.
(6) Set based on the integer price level of the exchange rate. This method doesn’t have much scientific basis, mainly because integer price levels have certain psychological support and resistance effects on the investing public.
(7) Set based on the dense trading area. Because the dense trading area will have a direct support and resistance effect on the exchange rate. A solid bottom that is broken through often transforms from a strong support area into a powerful resistance area.
(8) Set the psychological price level as the stop-loss based on one’s experience. When an investor has been paying attention to a certain exchange rate for a long time and has a deep understanding of the exchange rate, the stop-loss set based on the psychological price level is often very effective. However, this method is not suitable for beginners and large capital forex traders.
Stop-loss is the primary tool for controlling the expansion of losses in forex trading. In its implementation, it is crucial to determine the specific location and timing of the stop-loss before entering the forex market. One must not wait until a loss has already occurred to consider what standard to use for stop-loss, as it is often too late by then. It is essential to consider how to respond if there is a misjudgment at the time of purchase and to establish a detailed stop-loss plan and criteria. Only by doing so can one be prepared for any eventuality.
VIII. Grid Trading Method Against Traditional Risk Management Principles
The grid trading method has its forex market because it fits the human nature of adding positions against the market trend. However, this method is used in specific markets. If the market is trending rather than ranging, this method can lead to disastrous results.
Since all financial markets inevitably have trending movements, a single mistake can wipe out all the profits made by this strategy. Of course, we have seen people use this method to profit steadily by improving it and incorporating monthly line research to avoid going against the major trend.
Grid trading should be avoided for news trading, especially when major news releases are released. For example, the release of the Federal Reserve interest rate resolution, the release of U.S. GDP data.
Let’s discuss the specific form of the grid trading method. The most basic form of this strategy is as follows: for example, we go long on EUR/USD and also long on USD/CHF (to hedge and reduce the risk of one-way movement). For going long on EUR/USD: place a buy order every 25 points within a 200-point range above and below the current price, with no stop-loss set, and a profit target of 25 points for closing positions. Similarly, for going long on USD/CHF: place a buy order every 25 points within a 200-point range above and below the current price, with no stop-loss set, and a profit target of 25 points for closing positions.
Check every few hours to see if any buy orders have been executed and closed for profit. Once an order has closed for profit, such as buying at 1.2000 and closing at 1.2025 for profit, then open another buy order at the original price of 1.2000. In other words, ensure there is a buy order every 25 points at all times.
If a buy order at a certain price has not yet closed for profit, do not open another order at that price. You can imagine that if EUR/USD rises, it will trigger a series of buy orders on EUR/USD to close for profit. At the same time, USD/CHF will inevitably fall, accumulating a batch of unclosed buy orders. If the price of EUR/USD then falls back, USD/CHF will rise, resulting in a series of profitable closings on USD/CHF, while accumulating a batch of unclosed buy orders on EUR/USD. If the price saws back and forth within a range, continue to close for profit and open new orders, execute and close for profit again.
The essence of this operation lies in the trading price sawing range; the trading positions are very small. For an account with $1,000, each order can only be 0.1 lots at most to ensure that a significant one-way linear movement does not cause a large number of unclosed losses and lead to a margin call.
The real grid trading method is not a short-term trading system. The larger the range of the net, the smaller the probability of the price running outside the net. However, short-term techniques help establish the grid.
Some people have integrated volatility breakouts, support and resistance levels, dynamic position sizes, multi-layer grids, and trailing stop-losses, which can control the capital drawdown within a very small range. It can be imagined that because the expansion of grid paper losses is exponentially rising in the direction of a trend, if someone can keep the capital drawdown very small, then their profit closing must be very impressive.
In addition, a method called regular grid closure proposed by someone named Jove involves closing the entire grid when the grid’s profit or loss reaches 10%. In this way, he can obtain 10% profits (because the forex market consolidates more than 80% of the time), and in other cases, only lose 10%.
His method is also worth considering, as it utilizes the advantages of the grid on the one hand and avoids the impact of long trends on the grid on the other.
However, closing the grid is ultimately admitting a loss. If there is a way to deal with the impact of long trends on the grid, then a permanent grid has greater potential in the future. Never admitting loss until closing for profit is the core idea of the grid trading method.
This is just my speculation, and it is difficult to say that there is reliable theoretical support. It can be imagined that after a year, the operating range has reached a new area. In this area, the volume of operations maybe 1-2 times larger than a year ago, and the impact of those orders hung at the farthest end a year ago on paper losses will not be so significant.
As long as it is always ensured that profitable closings continuously increase available funds, the closer the orders are to the current position, the larger their size, and the greater their impact on the account.
The risk of a purely mechanical grid is very high; it can be said that the risk and reward are almost disproportionate, and perhaps a capital of 100,000 yuan needs to be prepared to ensure a final profit of 10,000 yuan.
IX. Conclusion
Please remember, that victory only belongs to forex traders who are proficient in the application of probability! Loss is a very real issue; you will always encounter these problems in trading.
The more severe your account’s losses, the more difficult it will be to return to the initial capital level, and the greater the effort required.
Take risks with a smaller ratio of capital. Of course, you also need to consider the issue of returns; too little capital or too much idle capital is not acceptable. 3% is the recommended ratio.
Pay attention to controlling the risk-reward ratio. The higher this ratio, the less you should enter trades. Before trading, look for opportunities with an ideal risk-reward ratio; do not enter the forex market blindly. It is unwise to bear 40 points of risk for 20 points of profit, but often people do so in trading.
We do not recommend the grid trading method, but it is worth understanding because it reveals a potential premise that it must be a ranging market to use this method. You should know the assumptions behind any trading method before using it correctly.
