Money Management Lesson 2

Welcome to Money Management part two, presented by DailyFX Education. The goal of this
video is to clearly and convincingly illustrate to you why money management is important.
We believe that money management is arguably the most important component to any
trading or investing approach. However, we have found it is not easy to convince other
traders, especially newer traders, that this is the case. In this video we are going to try to
more clearly illustrate the benefits of money management by reviewing the back-tested
performances of an actual trading strategy. By providing you with a more practical
illustration of money management, we hope that youll more clearly see its value and begin
applying sound money management techniques to your trading approach.
But before getting started, lets quickly review the two money management guidelines that
we introduced in the first video as the merit of these guidelines is what well be testing
throughout this video.
When setting stops and limits, we recommended that your limit distance should usually be
at least twice as much as your stop distance. Another way of saying this is that your risk to
reward ratio should be 1:2 or greater.

So if you have a 100 pip stop, we recommend setting your limit at least 200 pips away from
your entry price. We also provided a guideline that can assist you with determining what
trade size to use, based on the size of your account. We suggested that you should never
risk more than 5% of your account equity at any one time. So if 5% of your account equity
was equal to $1,000 and you planned to open a trade with a 100 pip stop loss, we
recommend that your trade size should not be greater than 100K. Lets briefly walk through
the math. A 100K trade has a $10 pip cost. And $10 per pip multiplied by a 100 pip stop
equals $1,000 the maximum that we want to risk at that time. We believe that these
guidelines are the foundation for a sound money management approach.

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Money Management Lesson 2

As I mentioned previously, our goal in this video is to prove to you that these guidelines are
important; that these guidelines are not just rooted in trading theory but can actually
provide real practical value in your trading. Throughout the remainder of this video well be
reviewing the back-tested performance results of a simple MACD strategy that was tested
several times with different money management settings. Well be reviewing a total of three
back-tests. One back-test will be considered our benchmark test, which meets both
guidelines outlined in the first video. While two other back-tests will meet one of the
guidelines while not meeting the other. Well consider these two tests to be sub-optimal.
The benchmark test uses a 1:2 risk to reward ratio when setting stops and limits and never
risks more than 5% of account equity at any one time. The first sub-optimal approach well
review uses a 2:1 risk to reward ratio while limiting the equity at risk to 5% on each trade.
The second sub-optimal approach uses a 1:2 risk to reward ratio while limiting the equity at
risk to 10% on each trade.
Now its important to point out that we are not concerned with the actual profit or loss of
the strategy. In fact, we believe that this type of test can be performed with just about any
strategy and you should be able to see similar correlations and outcomes that are presented
in this video. If youre a bit skeptical, grab a demo account and give it a shot with one of
your own strategies and let us know what you find out.
As I just mentioned, were not concerned with the actual profit and loss of the strategy.
What we want focus on is the relationship between the performance of the benchmark test
and the sub-optimal tests. By doing this, well be able to more clearly see the effects of
good or bad money management.
Now were almost ready to begin pulling up some charts, but first let me briefly explain the
strategy that was used for this video. An 8-hour chart was used to locate the direction of
the trend and trades were only placed in the direction of the 8-hour trend. Then a 2-hour
chart was used to locate MACD crossovers, which were used to signal entries. A 100 pip
stop loss was used on every trade, no matter what. And the testing period was from July
2007 through July 2009. This provided between 100-200 trades, depending on how the
money management was set.
GUIDELINE #1
Ok, lets bring up our first chart. This chart here shows the back-tested performance results
for our benchmark money management approach. So a 1:2 risk to reward ratio was used
and 5% of account equity was ever risked at risked on each trade. To be more specific, each
trade used a 100 pip stop loss and a 200 pip limit.

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Money Management Lesson 2

This new chart shows the back-tested performance of one of our sub-optimal money
management tests. In this back-test a 100 pip stop was used but only a 50 pip limit was
used. That means the risk to reward ratio was 2:1 and that we were risking twice as much
on each trade as we hoped to gain. To make sure that we can really focus on the
importance of our first money management guideline, we limited the maximum risk to 5%
on each trade on this back-test as well. So only the risk to reward ratios were different
between the two tests.
There are two things that I am immediately interested in when comparing these
performances. When considering the first year of trading, from July 2007 to July 2008, the
optimal benchmark money management test moved nearly lock-step with the sub-optimal
test only performing slightly better most of the time. This of course is to be expected as
both strategies utilized a 100 pip stop loss. However, the optimal strategy did use a 200 pip
limit versus a 50 pip limit, so it was able to recoup its losses a bit better and thus performed
a bit better overall throughout the first year of testing.

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So the performance during year one was better when a 1:2 risk to reward ratio, even
though it was only marginally so. For many of you, this might not be too visually
compelling. At least if we just compare the first year of trading. However, when we consider
year two, when the strategy actually started performing better, the argument becomes even
more compelling.
When times were good for the MACD strategy, the benchmark settings easily outperformed
the less optimal test for 2 reasons. First, with a 1 : 2 RR Ratio, the strategy is gaining twice
as much on the winning trades as it is losing on the losing trades. Even being right 44% of
the time means the winners are easily outpacing the losers. Second, the benchmark
strategy started the second year of trading at a higher equity point. Even though it wasnt
drastically higher, it was higher none-the-less. Therefore, when the strategy began
performing well, the benchmark strategy had a head start if you will on the sub-optimal
strategy.

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Take a moment to focus on the distance and separation between the two charts. The
nominal returns or losses are not of concern as a traders strategy and market conditions
can vary so drastically from what were seeing here. But the types of relationships that you
can see here between the two back-tests, the fact that the benchmark strategy can recover
from losses better than the less optimal strategy and the fact that the benchmark strategy
can really outpace the suboptimal strategy when times are good, are all patterns and
relationships that should hold up no matter what strategy youre using or what the market
conditions are at the time.
This advantage can be spelled out in a different way tooduring the first 12 months the
average pip return per trade on the sub-optimal test was -16 pips. For the benchmark test,
the average was -14 pips. Thats not much of an advantage, but an advantage none-theless. And its important to remember that this was during a time of drawdown.
Another important thing to consider when comparing the results of year one was the
number of trades each strategy placed. The avg pip per trade difference may seem neglible,
but the sub-optimal strategy placed 29 more trades than the benchmark strategy. Thats
because the benchmark strategy looked for larger gains when trades were going in its favor.
So the winners took longer to materialize, keeping the strategy from opening as many
trades when market conditions werent as favorable for the strategy. So again, the average
loss per trade is roughly equivalent in both tests, however, because the sub-optimal test
placed 29 more trades, it suffered greater overall losses.
Lets briefly compare this type of data for the second year of testing.
The average pip return/trade for the sub-optimal test improved dramatically, going from -16
pips/trade to almost 12 pips/trade. The benchmark test made a complete turnaround as
well, averaging over 33 pips/trade, up from -14. The advantage achieved by the optimal

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benchmark test when market conditions were in favor of my MACD strategy was
staggering outperforming the sub-optimal test by a full 21 pips/trade on average. When
considering how many trades were placed during the second year of trading, the suboptimal test placed 18 more trades than the benchmark test, which is to be expected, as
the profit target was quite a bit lower than the benchmark test. But the takeaway point from
this is that even with fewer overall trades, throughout the entire two years, the benchmark
test consistently outperformed the sub-optimal test.

To conclude this section, Id like to briefly discuss win percentages. When considering the
full two years of backtesting, the sub-optimal test had a win% of 65%. That means 65
percent of the trades it placed were profitable. While the optimal benchmark test had a win
percentage of only 38%. But take a look at the graphs. Who came out at the end of the
year not only profitable but with some sizable gains? The benchmark test. And its all largely
because of the ratio that we set between the stops and the limits. By looking to gain at least
twice as much as youre willing to risk on your trades and also being able to achieve a win%
of about 40% or better, you really set yourself up for a more stress-free trading
environment. Meeting these two conditions can help you from having to be right all the
time. And you can help keep yourself out of placing more trades when your strategy isnt
performing as well.
What we just discussed should clearly help illustrate the benefit of money management
guideline number one. Now lets take a quick look at money management guideline number
two.
GUIDELINE #2
Well begin again with our optimal benchmark test. So here we have a 1:2 risk to reward
ratio and a 5% maximum risk per trade. In this chart, which is our second sub-optimal test,

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we have a 1:2 risk to reward ratio with a 10% maximum risk per trade. So in this test,
were keeping our stops and limits consistent. Both tests used a 100 pip stop and a 200 pip
limit. However, the sub-optimal test put more of the account equity at risk at any one time
which was 10% per trade vs. 5%.

So, the same stops and limits but bigger trade sizes, which means more leverage. And
remember, leverage magnifies gains as well as losses. There is no doubt that leverage is
typically an attractive feature to new traders. Its often seen as a way to make quick
money. But we cant stress it enough, leverage is dangerous and should be used very
cautiously. And dont forget, leverage is only beneficial when you pick the right side of the
trade. But we all know thats not always so easy, especially for newer traders. If it were, we
wouldnt need trading courses like this one.
Now it wont be as necessary to go into as much detail here as the charts are very straight
forward. It is probably very apparent to you that both tests seem to track each others
movements fairly closely, with only the amplitude or velocity of the movements being
magnified with the sub-optimal test.

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Just think about it, with the same stops and limits, both tests were likely in the majority of
the same trades, for the same lengths of time. The only difference being the trade size.
Thats why you can see two charts that seem to move in tandem with the sub-optimal only
making larger dips or spikes.
Now I will admit, the large drawdown that the sub-optimal trade experienced during the
first year of testing might not have happened with an alternative trading strategy or if
market conditions where different at the time. But for the purposes of this video, Im glad it
did, as this type of drawdown can really affect trading psychology. After about 7 months of
trading, the sub-optimal test was down from its starting equity of $10,000 to around
$3,000. Thats a loss of about 70% of capital. And account equity stayed around the $3,000
mark for about 5 months. Ask yourself honestly, could you stomach that kind of a
drawdown? Even if you could, is it worth taking on that potential risk to only potentially reap
larger gains from the use of leverage?
Now you could certainly argue that even the benchmark strategy took on a large loss, in
this case about 40% at its worst point. But thats really not the point. Remember, the
nominal performance of the tests is not really what were concerned with. Were concerned
with the relationship between the two tests. And you can clearly see that when the market
was not suited for this strategy the sub-optimal test took on substantially greater losses
than the benchmark test.
And even more importantly, consider this. Its safe to say that most people are willing to
risk more of their account equity at any one time because they have the hope and
expectation that they will end up magnifying their returns. But again, these charts provide
so much insight into the benefits of sound money management. Look at the equity level of
both tests at the conclusion of two years of testing. In fact, look at the equity level of both
tests throughout the entire two years of testing. There was rarely a time that the riskier test

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(which used more leverage) ever outperformed the less risky test, which used the
benchmark money management. Now this specific outcome does not relate to all market
conditions or trading examples. If we had only run our test from July of 2008 to July of
2009, it is likely that the sub-optimal test would have greatly outperformed the benchmark
test. But thats only because market conditions were favorable at that time for the MACD
strategy. And you and I both know the future is uncertain and we have no way of knowing
for sure if market conditions will be favorable for our strategy or not. So by limiting the
amount of risk that we expose ourselves to we can maintain more account equity and have
more staying power in the market.
I will conclude by saying, that there are certainly times where cautiously using more
leverage might make sense. But it should be very clear from this example what the dangers
are and why we recommend to traders to never risk more than 5% of their account equity
at any one time.
We hope you found this video helpful and hope that it provided you with a more practical
analysis of money management and showed you why its important. We encourage you to
join us for a live webinar on money management with one of our course instructors. In the
live webinars, we will discuss real time trade set ups and show you how to properly set the
money management for those trades. We will also have a live Q & A session where you can
ask the instructors specific money management questions.
Thanks for watching this video and good luck with your trading.

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