Mark Thomas — Trade On Track
Here’s where things get really interesting. The advanced money management rules used in the NYTime time-based forex strategy make the difference between a system that wins some of the time and a system that can keep producing consistent profits.
Most traders hear the term “Money Management” and assume it’s going to be the same old “only risk 2% of your account per trade” rule. I’m not saying that’s a bad rule, because it is very good and I use it myself on the majority of my trades. Also, it’s certainly a lot better than throwing 5% at a trade and if that doesn’t win, then throwing 10% at the next trade to try to recover your losses on the first one! This type of trading equals “account blow-up” in next to no time. No, the NYTime MM rules are much more interesting …
Before getting into the details, let me cover the bases first, so that new traders understand basic risk management. It is good practice to only risk a certain amount of your trading account balance on each trade. Let’s say we only want to risk 2% per trade. The way you achieve this is to either alter the position of your stop loss OR alter the number of lots (or mini-lots or micro-lots) you are trading so that if your stop is hit, you only lose 2% of your account. There are many online calculators which let you work this out quickly, here’s a quick/easy one: www.forexcalc.com.
There is some reasoning behind doing things this way:
- It means you’re consistently risking the same amount trade after trade. Without consistency you have the potential to lose on your bigger positions and win on your smaller positions, thus losing money overall.
- A number of losing trades in a row shouldn’t wipe out your trading account. For instance, if you’re risking 2% per trade and you have 10 losses in a row, your account will be down 20% (roughly). You can recover from this if you start to collect some nice wins again, but it’s much more difficult to recover from losses of 60% or 70% or more.
- Forex trading is not about making a million dollars overnight. A mentality of reckless risk to try to attain large profits can quickly lead to ruin. You’re much better off risking a little each trade with the aim of making a little more.
I first tested NYTime using a fixed risk level per trade. The results in year 1 were quite different from the results in year 2. This was understandable because the number of pips caught in year 1 was 587, while the number of pips caught in year 2 was 2006. On average this is still quite good, but was a little too inconsistent for my liking. Here are the monthly results using a fixed 2% risk per trade:
The Running Balance is calculated using a starting account balance of $1000. You can see that there was quite a large drawdown in year 1 (39.3%), but it did finish up in profit. Year two was very profitable with reasonable drawdowns.
Many traders would be more than happy with these results and you may like to trade the NYTime strategy using a fixed 2% risk per trade yourself (or even higher). I was looking for something a bit more consistent from year to year so I altered the strategy somewhat to make that happen. The MM rules I use have a variable risk level based on whether you’re currently winning trades or you’re losing trades. The system works as follows:
Starting risk: 2.5%
If a trade loses, the risk is reduced by 1.0% for the next trade.
We keep reducing by 1% until we get to 0. Yes, we go as low as zero which means we’re not risking anything at that point.
If we win a trade and the current risk level is 0, then we jump straight back up to 2.5% risk for the next trade.
If we win a trade but we’re not currently at a 0 risk level, then the risk increases by 0.5% for the next trade.
We keep increasing the risk by 0.5% for each winning trade until we get to a maximum of 4%.
This may sound a little complex but it’s really quite logical. If the strategy starts losing, then it tends to lose several in a row. If this starts happening, we back off quickly, by reducing risk by 1% for each loss. If we’re back into winning trades, we gradually increase our risk level up to 4%, which is still reasonably conservative considering we only get to that if we have 4 or more winning trades in a row.
I once read a trading psychology book that had the quote “If you’re hot, you’re hot. If you’re not, you’re not”. This is so true in trading, even with a strictly mechanical system like NYTime. If the system is winning, it wins well (like the 2nd year). If it’s losing, it may lose quite a few in a row. By reducing our risk right to 0%, then we can have any number of losing trades in a row and we still have our trading account intact for when the system starts picking up again.
Remember our year 1 pips were 587 and our year 2 pips were 2006. Have a look at the revised figures once these new MM rules were put in place:
Isn’t that really quite amazing? Year 1 actually had a better return even though it had less than 1/3rd the pips that year 2 had. Our drawdown for both years is kept at a much better value (maximum of 15.57%), and our equity curves for both years are quite consistent. Also, we haven’t really lost anything in terms of dollars made.
These are the MM rules I would choose for myself because they result in better consistency in the long run, with less drawdown. The MM rules themselves also seem to mimic the trading strategy philosophy of cutting losses short (reduce risk to zero) while letting profits run (increase risk up to a reasonable level). It is of course your choice as to what MM strategy you use if you adopt the NYTime system or any other trading system. This article at least gives you two different ways of managing your money and shows you the dramatic affect on overall profits that it can have.
In the next article I will describe when to move the stop loss and when to exit the trade.