The Mathematics of Money Management in Forex Trading

As Forex traders we have to come to terms with the elements of trading that are completely out of our control. In order to progress we have to accept, (even begin to embrace), that lack of control very early on in our personal trading evolution. Price is obviously the most prominent trading factor bar none and equally there’s one immutable fact, price is a trading factor that we have absolutely no control over. For us to become successful forex traders we have to accept that we have no control over what price will do, we can only take a position in our chosen market based on our interpretation of probability. The risk in the market is not what we want it to be. The risk is what the market imposes upon us.

That probable outcome and our ‘judgement call’ can be underscored by; pattern recognition, indicators, price action, waves, fundamental news or a combination of several of the aforementioned mentioned mechanisms. However, using any of the aforementioned does not guarantee success, only underpinning the technique with sound money management will create long term success.

Many new traders use the phrase “I was right” when an individual trade is successful. However, you’re not right or wrong, if you reduce trading down to being right or wrong, whilst accepting that price is not under your control, how can you be right? Can a trader who accepts the factor of probability underscoring his or her performance genuinely give themselves credit for being right, or moreover should they in fact credit themselves with sticking their plan? You cannot realistically give yourself credit for ‘guessing’ right, but you can congratulate yourself for planning your trades and trading your plan.

There are aspects of trading that we can control, emotions being one, we can also control risk per trade and control that risk almost to the pip by using mathematics. We can control; stops, limits, percentage losses of our accounts per day, per week, per month. In order to be successful it’s incumbent on us to leverage that single and most important element of control we can have over our trading.

Ralph Vince has written several theoretical books on the topic of money management in trading. He illustrates, time and time again, that there’s a mathematical certainty you will go broke if you don’t trade systematically by controlling risk. Another celebrated trading mind, Van Tharp, has dined out several times on the strength of the following anecdote concerning Ralph Vince’s theory of money management…
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Source: FX Central Clearing Ltd. (FXCC BLOG)