1st things first. Please reread my post on RISK here. It needs to be clear that everything I do in the trading game is based on risking around 2% of my account in a trade. This applies to Futures, Commodities, and Forex.
In equity options, I have shifted over the years to considering the amount of premium that I pay (or would have to pay in the case of a credit spread going belly up) as my total risk. However, knowing that extrinsic value (time value) plays a role in an options value, I will sometime stretch my risk to up to 2.5% of my account for options. This differs significantly from some organizations that tout stacking gains by taking profit at 20% and losses at 10%.
If the technicals of an underlying stock says it is going up and I buy a call option for $200 in premium, I kiss that premium goodbye. Then if the stock goes up (and the option premium with it), I want to stay in the trade as long as the charts say that the stock will continue to go up. When I eventually sell that option for a profit or loss, I welcome the capital back into my account with open arms (a smile if a loss and a happy dance if a profit).
My shift away from “stacking gains” happened approximately two years ago when I started studying and eventually trading Forex.
Over the next several weeks, I will be writing five separate articles on the building blocks of margin based asset class trading system. The focus will be Forex, however these types of systems work across all classes, even options if applied in the correct way. The foundation of all trading was addressed last week - Psychology, aka position sizing based on your own personal threshold for drawdown if you see seven to eight losses in a row. Again, my number is 16% before I start doing stupid things. I therefore use 2% per trade.
Forex 101
Trading Forex (or Futures) is far different than options as we use margin (my broker offers me 100 to 1) to take a long or short position in a currency pair, e.g., AUD.CHF. Profit and loss is based on my position size times the size of the move in “pips.” To get a better understanding of the value of a pip in any given currency pair see Pip Value Calculator. There are many resources out there - BabyPips in the link for the calculator is one of the best for basic info. I would strongly suggest that readers peruse their website (no affiliate link here by the way, just a damned good resource).
Position sizing is based on the maximum number of pips you are willing to lose (which is also where I always set a stop loss. The following TradingView chart shows how I determine where my stop is set.
The most important indicator (for me) in the trading game: Average True Range (ATR)
For the math nerds here, ATR is calculated as follows:
ATR is essentially a measure of the average price volatility over a given period of time. The standard is a simple moving average over 14 days.
My trading formula is very simple. I position size all of my Forex trades to a stop value of 1.5 x ATR. What does this mean and how do I do this? Also very simple - I use a Position Size Calculator. In the AUD.CHF chart example, I am willing to accept a 95 pip loss (note that my broker only allows 1/2 pip increments so there is some rounding).
If my account value is $10,000, my risk is 2%, and my stop is 95 pips, I plug the requested numbers in to the calculator. This gives me a max potential position size of 19,828.4211. In this case, I would trade 20,000 units.
Using the ATR for Money Management
The following was not developed by me - I learned it from a podcast by NoNonsenseForex.com, who puts out very good guidance on developing your own system (I would encourage anyone with hundreds of hours of time on their hands to go down this rabbit hole - it is worth it). The below also shows how I enter the orders into my Interactive Brokers account.
Position size to 1.5 x ATR
Set a Bracket Order by clicking the “advanced+” tab with a stop loss at entry minus 1.5 x ATR + take profit at a reasonable technical level of at least 2 to 3 x ATR (set a far target).
As soon as I am filled, I set up a separate One Cancels Other (OCO) order to exit 1/2 at 1 x ATR or 1/2 at my previously determined stop loss of 1.5 x ATR.
Then, I adjust the Bracket Order down from 20,000 to 10,000 in the AUD.CHF case.
In doing this method, I will have two working orders that will cancel out if one side is filled, profit or loss. In the case of the loss side, both orders will fill at my 1.5 x ATR stop (and the two take profit orders will be cancelled automatically). In the case of the 1st take profit being filled on 1/2 of the position, one stop for the other 1/2 position will be automatically cancelled (leaving the bracket order for the stop and take profit on the other 1/2 open).
If and when my take profit order is filled, I move the stop portion of the bracket order up to my original entry price. In this way, I am guaranteed to have profit on the books if stopped out on the other 1/2.
Now things become interesting… As soon as the price action of the currency pair closes more than the original 1.5 x ATR from my entry price, I adjust the stop portion of the bracket order to a trailing stop equal to 1.5 x ATR.
Closing the position. The following scenarios are possible:
Worse case - the entire position is stopped out (both the stop portion of the bracket order and OCO orders).
Manual stop out at less than the position size stop (based on a “Exit Indicator,” to be covered in a separate article next week.)
Take Profit on 1/2 at 1 x ATR + stop out at break even on second 1/2.
Take Profit on 1/2 at 1 x ATR + Manual stop out based on method noted in b.
Take Profit on 1/2 at 1 x ATR + trailing stop. This method will potentially be modified to tighten the stop once the trailing stop is in place for 10 candles.
In practice, If I am stopped out at a loss, it is rarely the worse case. I am also more frequently stopped out at break even on 1/2 after having taken 1 x ATR profit on the first 1/2. Generally, the 1/2 Take Profits cover most of the Stop Losses. Where I gain is on the big trends, otherwise known as “runners.”
Here is an example of my current system trades on the daily candles of NZD.CAD.
13 wins and 6 losses. 6 of the 11 are runners. The current trade can be defined as a MAJOR runner.
Profitability based on a $10,000 account is as follows. It considers that the current trade is closed at the current stop (high minus 1.5 x ATR). It is actually still open.
Courtesy of TraderSync
Note that I am able to run a daily system on a total of 28 forex pairs spread between AUD, CAD, CHF, GBP, JPY, NZD, and USD. I tend to avoid a few pairs such as EUR.USD. Decision making is between 16:00 and 16:30 New York time and orders are placed around 16:40 New York time.
Conclusion
As I mentioned above - I take my losses with a smile and do a happy dance when I win.
The purpose of this post was to cover the money management rules that I personally follow. I have found that having a structured approach to how I take both losses and profits has added yet another layer to overcoming the negative aspects of trading psychology. It has contributed to a stress free sustainable growth to my account. These principles can and should be applied to trading all types of asset classes.
Next week, I will cover the first phase of my multiple layered personal system - the baseline.
Below is a summary of current in-play as well as a watch list for forex trades in-development for paid subscribers.
I am still in the below trade, which was alerted via Telegram last Tuesday. This doesn’t mean if I wasn’t in the trade that I would enter. I do not have an exit signal yet (it may come today); I have not yet been stopped out yet; I have not yet hit the 1/2 profit take level. I am following the money management rules I set out in this post.
The following currency pairs are on my watch list, meaning they may trigger an EOD (16:40 New York time) trade sometime in the next week:
AUD.JPY Long (Descending trendline break)
AUD.NZD Short (Low Base)
CAD.JPY Short (Low Base)
CHF.JPY Long
EUR.NZD Short (Low Base)
GBP.NZD Short (Low Base)
GBP.USD Long (High Base)
I have the two strong contenders for an earlier alert on:
GBP.JPY Long on a daily close above 169
NZD.JPY Short on a reversal pattern, Long on a daily close above 88.
For those not on the private Telegram Channel, I alerted that I had a "buy stop" order in place for GBP.CHF yesterday (my order was for 34,000 units). The order filled in my sleep. This morning, I adjusted my stops and take profit in exactly the same way as described in this post. My 1st take profit at 1 x ATR was filled today and I adjusted the stop to my entry. Price action surpassed 1.5 x ATR a few hours ago and my stop has been adjusted into a trailing stop, which is now 6 pips above my entry.
This is how money management works. At this point, I don't need to even look at this one. It will run as long as it will run.
Excellent post!