We are going to discuss a method that determines how much to risk based on the probability of winning trades. Let’s begin with a simple premise. If I had a Forex currency trading system that made 100% winning trades, money management would be very easy. You risk all of your money on every trade. Why not? As long as your stops were not wider than the margin requirement you could risk 100% every time. Now this is not reality and most good systems are profitable between 50% and 90% of the time.
The first thing in constructing a money management system is to consider the number of times the system is right. The higher the probability of winning trades the more we can risk. The lower the probability of winning trades the less we can risk. I am also going to make an assumption, if you permit me, that all the trades risk about the same amount of pips.
To develop this let us first create an imaginary system. The trades with this system are profitable 50% of the time. Now if we make 100 trades we can ask, “How many times can we get one trade in a row that will lose money?” The answer is 50. The answer is obvious but we are going to use an equation that will take us in the direction we want to go. The total number of possible losing trades of a 50% probability system is 50 out of 100. We are going to come up with the same answer only using a simple equation.
You divide the total trades by total negative trades and you get 2. You take 2 to the power of 1 (1 trade in a row) which is 2 and divide that into 100 trades. The answer is 50. As we develop these numbers you will see what this formula does. Now let’s go to the next level. How many times can we get 2 trades in a row that will lose money?
You now take 2 (100 trades/50 losses) to the power of 2 (2 trades in a row) which is 4 and divide that into 100 trades. The answer is 25. 25 is the correct answer to this problem. So far our equation looks like it works, but something happens when we go to 3 in a row. We again ask our question, “How many times can we get 3 trades in a row that will lose money?” If you do this out mechanically you will get 16. But using our trick formula you take 2 (100 trades/50 losses) to the power of 3 (3 trades in a row) which is 8 and divide that into 100 trades. The answer is 12.5. Now it is time to use the power of a spreadsheet. When we set this up we will be able to change our values to help define a method of money management. Let’s create a table with our 50% wins system using this method.
Now we have a base to build a money management system. We have labeled our first column as “No. of Losses in a Row”. Remember our very first example? One lost in a row can happen 50 times in 100 trades. Looking at our columns we see 2 losses in a row can happen 25 times. 3 is 12.5. Now what number does the number of losses in a row become impossible? In other words, when does the number of losses in a row become less than 1. In the 100 Trades column the answer is 7. So our conclusion is if we have a system that has a 50% probability of being profitable this chart says there will never be 7 trades in a row that are losers, because 7 losses in a row is less than one, and in effect that is zero. You cannot make a .78125 trade.
Even if this conclusion is not true and even if the laws of probability are not applied correctly here, we have a desired outcome. This is important. You will see when the values are changed the numbers change in the direction we want them to change. What do I mean by this? The logic is, in trading a system, the lower the percentage of being right, the less money we want to risk per trade. The higher the accuracy of a system the more we want to risk per trade. We also get another piece of information from this table. The more trades we make the greater the chances are that we will get x “No. of Losses in a Row” and the higher the “No. of Losses in a Row” can be. Compare the values for 1000 trades. When do we hit our magic less than one value?
Let’s take our next step in managing our money. You may not agree with this logic but the important point here is this next step moves us toward a desired direction in managing our money. Take the time to think this through. With this imaginary trading system we want to determine when we should call it quits. How much of our capital do we have to lose to abandon this system? Let’s choose 50% of our capital as our cut off point. We now have a number that produces less than one which is 7. We don’t want to lose 50% of our capital so we take 50% and divide that by 7 and get 7.14 or roughly 7%. We can now have a system that tells us to never risk 7% of our capital in a system that makes 50% profitable trades in 100 trades. Again let me emphasize that if you change the values in a spreadsheet with this system, the numbers will change in the direction common sense will tell you to change. If we don’t want a drawdown of more than 35% you will risk less per trade.
This money management also adjusts with the number of trades. If we have more trades, wouldn’t you agree that the odds are higher that we could get 7 losses in a row? Let me show you what I mean. Let’s take a more active trading system. For the sake of clarity I created a column with 1000 trades and 7 losses in a row is no longer under one. Our magic number under one is now 10. How long does it take a system to trade 1000 trades? With our imaginary system we find it makes 50 trades a month, so it will take 20 months (a little over 1 ½ years) to trade 1000 trades. What percent of your capital would you risk with this scenario? 50% (max drawdown) divided by 10 trades is 5%. Our goal of staying with a system for a longer time will cause us to risk less capital on each trade.
We are now at a point in our money management that if you know the probability of profitable trades, how much capital we are willing to lose, and how many trades the system makes in a month, then we can determine how much capital to risk with each trade so we can stay with this system a long time.
Let me give you some final thoughts. I worked with this method over 15 years ago when I was trading Futures. Since then I have used several other methods of money management but working with this idea gave me an insight that I use to this day. If I am trading a proven system and I feel market conditions have not changed to the point of invalidating my method, then if I take a number of losses in a row the chances of the next trade winning gets higher and higher. Another way to look at this is if I want to improve my chances of a winning trade I can wait until there are 2 or 3 losing trades in a row and my odds go up that the next trade will be profitable.
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