Money Management

The first lesson I learnt (hard way) when I started trading was to manage my money and risk & reward ratio. Let me ask you a simple question? If you toss a coin, what's your probability of winning? 50%? Right?

When you enter into a market randomly, you still have 50% odds in your favour, What if I tell you that you get £9 everytime you get heads, and loss £3 for tails, and you win 50% time. Are you making money or losing money?

So to illustrate my point, out of 10 times, if you get 5 heads and 5 tails, you would still end up making profit.

5 * £9 = £45 for heads and 5 * £3 = £15 for tails, so £45 - £15 = £30.

This is called Risk & Reward ratio. In the above senario, my risk & reward ratio is: 1: 3. 1 profit = 3 losses. The same principle applies to trading.

Now back to Money Management, the above senario wouldn't have been possible if I had gamled the above ratio on just 1 trade. Ideally, you should not loss more than 5% of your capital in any trade. That gives you 95% more time to apply the above risk & reward ratio adding it to your probability.

So before you come up with a strategy or start using somebody else's strategy, make sure that your risk & reward ratio is reasonable. Personally, I wouldn't trade anything below 1:3 ratio. When working out a ratio, you also have to make sure that your risk & reward ratio is feasible, if you are trading a 1 hour chart, and your target is 30 pips, then SL at 10 pips is too risky considering you would pay 3 pips spead + volatility.

Risk & Reward ratio has to be practical. If your risk & reward ratio is 1:1, then you need higher success rate, if your risk & reward ratio is 1:3, even 50% success rate would make you money.