Put the odds in your favour

I had some interesting conversations with FXI members about money management issues over the last few weeks. My impression was that especially newbies has a lack of knowledge about money management thoughts. That is why I want to share some thoughts about this important topic. I want to stress that these explanations are NOT the Holy Gral. Feel free and post any comments and suggestions to that topic - we will all learn from these.

As a Trader you only can make money with your money. If you lost all your money you are out of the game. That is why it is so important to have a "battle" plan and how you can survive. To survive means to have enough money to enter into the next trade. If you risk 10% of your initial capital you can have 10 losses in a row, before you run out of cash. The probability to have 10 losers in a row is quite high. You can calculate it as:

10LoserInARow = 0.5^10
10LoserInARow = 0.0009765 = 0.009765%

As a general rule you can say:

x Loser in a row = 0.5^x

If you think that 0.009% is quite low and you will never have 10 losers in a row, I have to disappoint you. My personal experience told me that 10 losers in a row are quite likely. To exclude this possibility and to prevent yourself from a financial disaster you cannot risk 10% per trade. The chances to whip yourself out of the market are too high.
You need to prepare yourself for these events. If you are very aggressive you can risk 5%. The general experience of life told you, that you should risk a maximum of 2% of your account equity at any given time. Trading with 1% or even less is stress-free trading. You have your emotions under control and you can make rational decisions. And if someone told you that you should only trade, if you can "afford" to loose the money, then this person had not understand our business. Again, if you run out of cash, you are out of business. (Or do you only build a house, if can afford it, that it will burn down? How silly is that?) - Remember trading is a business.
Ok, then we need a plan to survive. The first step we have already done. We know that we only trade with a maximum of 2% of our initial capital.
The next step is to find good trade setups with at least a 2:1 winning ratio. That means that for every pip you loose, you have to win 2. With a risk of 30 Pips you need a profit target of 60 Pips or even more. And I think some facts are quite comfortable for a stress-free trading:

1. With a 2:1 winning ratio you only need a 34% profitable trades to survive.
   
2. If you risk a fixed percentage of your current account balance you will have a compounded interest effect. You risk more (in terms of pips) with a growing account balance and less with a decreasing account balance.
   

If you follow this simple rules you will have a greater possibility to survive.