Money Management

Many Forex traders experience difficulties following trading rule 101: “Cut your losses early and let your profits run”. Unfortunately this seems hard for many as they watch their account equity dwindle on some ill-advised position whilst being eager to take every profit early in the move. In this article I will present you with a number of options to avoid this trading mistake. I will discuss a number of money management strategies that may just be the difference between earning money and losing money in this fast paced market. My aim is to take the stress out of trading for you and make it a profitable career.

Let us discuss now the fear of taking losses and the fear of letting winners run. In face of a loss the trader first needs to accept that her original trading idea is void. Whatever the reason was why the position was entered - now the time has come to accept defeat and look for a new opportunity. But instead of closing the position the trader finds new reasons why it is still a good trade. Possibly he adds to the losing position and hopes that it turns. Instead of turning the position drops further and by now the loss has turned into a substantial drawdown. Now our trader gets a bit panicky. He doubles the whole position because he thinks the next support level will hold. But of course this time it doesn’t. The original small position by now has quadrupled and the losses keep on adding up. Finally the trader closes the position for a very substantial drawdown and stops trading for the day. He is so stressed by now that it is impossible to continue trading. To make matters worse, whilst this whole disaster happened there were multiple entry signals on different currency pairs that would have yielded very good trades. When one imagines this situation – and I guess most of my readers have been in it themselves, a documentary about Paul Tudor Jones comes to mind. On the wall of his office he has a little sign that reads: “Losers average losers”. I advice you now to write this sentence on an empty sheet of paper in capital letters and stick it to the wall right next to your trading screens. The next time you want to average down, you can decide yourself if you follow the rules of the founder of Tudor Investment Corporation, a multi-billion dollar hedge fund. Do you really cave in to your emotions and disregard this crucial trading rule?

That being said, there are situations when an average down does make sense. First of all when you have defined an attractive price range where you want to enter your position, you may develop a strategy that allows for a little bit of leeway. Let us assume you divide your desired position into three equal parts. In our discussion you identified the Eurodollar 1.4750-70 as a good long entry price range with a stop loss at 1.4530, and price is coming down and just touched 70. What do you do? You divide the 20 pips price range into 3 equal parts and enter with 1/3 of the desired position at each level. For the sake of argument we assume you enter part of your position every 10 pips that it goes against you in the 50-70 range. So the first 1/3 is taken at 1.4570, the second third is taken at 1.4560, and the remainder is taken at 1.4550. Your stop loss is still at 1.4530 but your average entry price is 1.4560. So instead of risking a 40 pip loss by entering the whole position you only risk 30 pips now. Chances are only 2/3 of your original position will be filled. It is up to the trader to decide if momentum starts to work in its favor or against it. If the position comes crashing down one might even consider to skip adding the last third of the position before momentum has changed. This in principle is not averaging down since it is part of a well defined strategy determined well in advance. On the other hand if only 2/3 of the position has been filled and the Eurodollar now turns with momentum above 70, the trader might still decide to add to the winning position. Even an entry at 80 would now translate to an entry at 70 for the whole position – just the risk profile at the beginning of the trade is substantially different.

In conclusion you have learned a way now to keep you from making a very expensive trading mistake. I have also shown you how to employ averaging down losers can be a successful strategy when implemented correctly. The difference lays in the detail – was it part of your strategy to begin with and did you adjust the position sizes accordingly.

Written by drs. Enno Hochhuth, FX trader and analyst with an undisclosed proprietary trading firm in Switzerland.