Fixed Ratio Money Management

It's been a while since I last blogged about Money Management, what many consider to be the most important yet overlooked subject in trading. As one of the three (3) pillars of trading success (the other two being Mind and Method), I therefore feel that I have an obligation to share more of my thoughts on the matter.

A personal favourite money management system of mine is outlined in great detail in Ryan Jones' book The Trading Game: Playing by the Numbers to Make Millions. In this book, he teaches 'Fixed Ratio' money management (what I will refer to as FRMM). Some FX traders assert that this is the best money management system for forex traders.

An important bit to note, Mr. Jones argues that FRMM will help any trading system as long as it is profitable over time. So, I would argue that trading using price action and support & resistance using pivot points (Mafia or otherwise) fits this requirement nicely. :-)

So, let's start putting FRMM into practice:

1. To show that this would work even for you small retail traders, let's assume that we begin trading with USD100 in our account.

2. Then, we need to pick how many pips profit we need to achieve before we start trading with more lots. Let's target an "easy" 200 pips a month or 10 pips/day for 20 trading days in a month.

3. Now we're ready to launch our trading terminal and start... just about. Before we start trading, we need to determine our trade size. Using 10:1 leverage, given that we have USD100 in our account, we therefore should be trading 1,000 units or 1 micro lot (USD0.10/pip) per trade. So, our daily target is 10 pips or USD1.00 per day . We will only increase to 2 micro lots after gaining 200 pips. After that, when we gain another 200 pips, we trade 3 micro lots... so on and so forth.

4. Should the broker give is 100:1 leverage, our margin requirement is simply 1% per micro lot traded, which comes up to USD10.

5. So, here's how FRMM would work:

Month 1: USD100 + (200 pips x USD0.10/pip = USD20 ) Total: USD120

We start with USD100 in our trading account and after 1 month of trading we gain 200 pips, and now have USD120 in our trading account. We are now at the next level. If our account balance has not reached USD120, we still trade 1 micro lot.

Month 2: USD120 + (200 pips x USD0.20/pip = USD40) Total: USD160

We now start month two with USD120 and gain 200 pips profit trading 2 micro lots. We now have USD160 in our trading account and are now on the next level. If the account has not reached USD160 we remain trading 2 micro lots.

Month 3: USD160 + (200 pips x USD0.30/pip = USD60) Total: USD220

We now start month three with USD160 and gain 200 pips profit trading 3 micro lots. We now have USD220 in our trading account and are now on the next level. If the account has not reached USD220 we remain trading 3 micro lots.

Month 4: USD220 + (200 pips x USD0.40/pip = USD80) Total: USD300

You now start month four with USD220 and gain 200 pips profit trading 4 micro lots. We now have USD300 in our trading account and are now on the next level. If the account has not reached USD300 we remain trading 4 micro lots.

Month 5: USD300 + (200 pips x USD0.50/pip = USD100) Total: USD400

You now start month four with USD300 and gain 200 pips profit trading 5 micro lots. We now have USD400 in our trading account and are now on the next level. If the account has not reached USD400 we remain trading 5 micro lots.

RESULTS:

Month 6: USD400 + (200 pips x USD0.60/pip = USD120) Total: USD520
Month 7: USD520 + (200 pips x USD0.70/pip = USD140) Total: USD660
Month 8: USD660 + (200 pips x USD0.80/pip = USD160) Total: USD820
Month 9: USD820 + (200 pips x USD0.90/pip = USD180) Total: USD1,000
Month 10: USD1,000 + (200 pips x USD1.00/pip = USD200) Total: USD1,200

What is incredible is that by just gaining an average of 10 pips a day, FRMM grows our account size asymmetrically. We've just turned USD100 turned into USD1,200 in 10 months! Yahoo! We don't need to bank mega pips daily, though that would be more than welcome. 10 measly pips a day on average and we're good. We can play around with the formula, to be more conservative than the above example. We can add more pips profit in the formula. For example, we can choose to increase the number of lots traded after gaining 400 pips instead of 200 pips. This would naturally mean slower growth.

Now, how realistic is 10 pips a day? In the above example, we start of trading 1 micro lot, i.e. USD0.10/pip with a daily target of 10 pips or USD1.00. Let's fix our risk per trade at 1% of equity, i.e. a stop-loss of 10 pips which works out to be USD0.10/pip x 10 pips = USD1.00. Risking 1% of equity per trade, let's target a nice reward:risk of 2:1 on every trade, i.e. we risk 10 pips for a gain of 20 pips.

Let's see how we perform if we do 10 trades a day as follows:

#1 - Lost: -10
#2 - Lost: -10
#3 - Lost: -10
#4 - Win: +20
#5 - Win: +20
#6 - Lost: -10
#7 - Lost: -10
#8 - Win: +20
#9 - Lost: -10
#10 - Win: +20

Total = +20 pips

We can see that we only need to win 4 out of 10 trades (40% win rate) and we will be up 20 pips for the day. Nice!

If you really suck at trading and suffer 10 straight losses however, you will be down 100 pips or USD10.00. You will need to turn off your trading platform and re-think your trading method/strategy. Remember, FRMM will only help trading systems that are profitable over time.

So, do try setting up an FRMM plan before you start your next live trade!

3 comments:

Mark said...

Very nice MM method. In theory, it works much better than fixed fractional MM.
kbp

Audrey Mackay said...

I believe that I am good at money management because I am the one handling our money very well.

Blogger said...

I suggest that you pick the most recommended Forex broker: eToro.

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Fixed Ratio Money Management

It's been a while since I last blogged about Money Management, what many consider to be the most important yet overlooked subject in trading. As one of the three (3) pillars of trading success (the other two being Mind and Method), I therefore feel that I have an obligation to share more of my thoughts on the matter.

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