Initially, the value of goods was expressed in terms of other goods, i.e. an economy based on barter between individual market participants. The obvious limitations of such a system encouraged establishing more generally accepted means of exchange at a fairly early stage in history, to set a common benchmark of value. In different economies, everything from teeth to feathers to pretty stones has served this purpose, but soon metals, in particular gold and silver, established themselves as an accepted means of payment as well as a reliable storage of value.
Originally, coins were simply minted from the preferred metal, but in stable political regimes the introduction of a paper form of governmental IOUs (I owe you) gained acceptance during the Middle Ages. Such IOUs, often introduced more successfully through force than persuasion were the basis of modern currencies.
Before World War I, most central banks supported their currencies with convertibility to gold. Although paper money could always be exchanged for gold, in reality this did not occur often, fostering the sometimes disastrous notion that there was not necessarily a need for full cover in the central reserves of the government.
At times, the ballooning supply of paper money without gold cover led to devastating inflation and resulting political instability. To protect local national interests, foreign exchange controls were increasingly introduced to prevent market forces from punishing monetary irresponsibility.
In the latter stages of World War II, the Bretton Woods agreement was reached on the initiative of the USA in July 1944. The Bretton Woods Conference rejected John Maynard Keynes suggestion for a new world reserve currency in favor of a system built on the US dollar. Other international institutions such as the IMF, the World Bank and GATT (General Agreement on Tariffs and Trade) were created in the same period as the emerging victors of WW2 searched for a way to avoid the destabilizing monetary crisis which led to the war. The Bretton Woods agreement resulted in a system of fixed exchange rates that partly reinstated the gold standard, fixing the US dollar at USD35/oz and fixing the other main currencies to the dollar - and was intended to be permanent.
The Bretton Woods system came under increasing pressure as national economies moved in different directions during the sixties. A number of realignments kept the system alive for a long time, but eventually Bretton Woods collapsed in the early seventies following president Nixon's suspension of the gold convertibility in August 1971. The dollar was no longer suitable as the sole international currency at a time when it was under severe pressure from increasing US budget and trade deficits.
The following decades have seen foreign exchange trading develop into the largest global market by far. Restrictions on capital flows have been removed in most countries, leaving the market forces free to adjust foreign exchange rates according to their perceived values.
But the idea of fixed exchange rates has by no means died. The EEC (European Economic Community) introduced a new system of fixed exchange rates in 1979, the European Monetary System. This attempt to fix exchange rates met with near extinction in 1992-93, when pent-up economic pressures forced devaluations of a number of weak European currencies. Nevertheless, the quest for currency stability has continued in Europe with the renewed attempt to not only fix currencies but actually replace many of them with the Euro in 2001.
The lack of sustainability in fixed foreign exchange rates gained new relevance with the events in South East Asia in the latter part of 1997, where currency after currency was devalued against the US dollar, leaving other fixed exchange rates, in particular in South America, looking very vulnerable.
But while commercial companies have had to face a much more volatile currency environment in recent years, investors and financial institutions have found a new playground. The size of foreign exchange markets now dwarfs any other investment market by a large factor. It is estimated that more than USD 3,000 billion is traded every day, far more than the world's stock and bond markets combined.
Thursday
Money Management .
This section is one of the most important sections you will ever read about trading.
Why is it important? Well, we are in the business of making money, and in order to make money we have to learn how to manage it. Ironically, this is one of the most overlooked areas in trading. Many traders are just anxious to get right into trading with no regards to their total account size. They simply determine how much they can stomach to lose in a single trade and hit the “trade” button. There’s a term for this type of investing….it’s called GAMBLING!
When you trade without money management rules, you are in fact gambling. You are not looking at the long term return on your investment. Instead you are only looking for that “jackpot”. Money management rules will not only protect us, but they will make us very profitable in the long run. If you don’t believe me, and you think that “gambling” is the way to get rich, then consider this example:
People go to Las Vegas all the time to gamble their money in hopes to win a big jackpot, and in fact, many people do win. So how in the world, are casino’s still making money if many individuals are winning jackpots? The answer is that while even though people win jackpots, in the long run, casino’s are still profitable because they rake in more money from the people that don’t win. That is where the term “the house always wins” comes from.
The truth is that casinos are just very rich statisticians. They know that in the long run, they will be the ones making the money—not the gamblers. Even if Joe Schmoe wins $100,000 jackpot in a slot machine, the casinos know that there will be 100 more gamblers who WON’T win that jackpot and the money will go right back in their pockets.
This is a classic example of how statisticians make money over gamblers. Even though both lose money, the statistician, or casino in this case, knows how to control their losses. Essentially, this is how money management works.If you learn how to control your losses, you will have a chance at being profitable.
You want to be the rich statistician…NOT the gambler because in the long run, you want to “always be the winner.”
So how do you become this rich statistician instead of a loser?
Why is it important? Well, we are in the business of making money, and in order to make money we have to learn how to manage it. Ironically, this is one of the most overlooked areas in trading. Many traders are just anxious to get right into trading with no regards to their total account size. They simply determine how much they can stomach to lose in a single trade and hit the “trade” button. There’s a term for this type of investing….it’s called GAMBLING!
When you trade without money management rules, you are in fact gambling. You are not looking at the long term return on your investment. Instead you are only looking for that “jackpot”. Money management rules will not only protect us, but they will make us very profitable in the long run. If you don’t believe me, and you think that “gambling” is the way to get rich, then consider this example:
People go to Las Vegas all the time to gamble their money in hopes to win a big jackpot, and in fact, many people do win. So how in the world, are casino’s still making money if many individuals are winning jackpots? The answer is that while even though people win jackpots, in the long run, casino’s are still profitable because they rake in more money from the people that don’t win. That is where the term “the house always wins” comes from.
The truth is that casinos are just very rich statisticians. They know that in the long run, they will be the ones making the money—not the gamblers. Even if Joe Schmoe wins $100,000 jackpot in a slot machine, the casinos know that there will be 100 more gamblers who WON’T win that jackpot and the money will go right back in their pockets.
This is a classic example of how statisticians make money over gamblers. Even though both lose money, the statistician, or casino in this case, knows how to control their losses. Essentially, this is how money management works.If you learn how to control your losses, you will have a chance at being profitable.
You want to be the rich statistician…NOT the gambler because in the long run, you want to “always be the winner.”
So how do you become this rich statistician instead of a loser?
Drawdown and Maximum Drawdown?
So we know that money management will make us money in the long run, but now we’d like to show you the other side of things. What would happen if you didn’t use money management rules?
Consider this example:
Let’s say you have a $100,000 and you lose $50,000. What percentage of your account have you lost? The answer is 50%. Simple enough. Now, what percentage of that $50,000 do you have to make in order to get back to your original $100,000? It’s not 50%--you’d have to make back 100% of your $50,000 to get back to your original $100,000. This is called drawdown. For this example, we would’ve had a 50% drawdown.
The point of that little illustration is that it is very easy to lose money and a lot harder to make it back. We know you’re saying to yourself, “I’m not going to lose 50% of my account in one trade.” Well we would certainly hope not!
However, what if you lost 3, 4, or even 10 trades in a row? That couldn’t possibly happen to you, right? (Sarcasm used) You have a trading system that wins 70% of the time, so there is NO way you could lose 10 trades in a row. (Even more sarcasm used)
Well, while you may have a good system, consider this example:
In trading, we are always looking for an edge. That is the whole reason why traders develop systems. A trading system that is 70% profitable sounds like a very good edge to have. But just because your trading system is 70% profitable, does that mean for every 100 trades you make, you will win 7 out of every 10?
The answer is that you don’t. You could lose the first 30 trades in a row and win the remaining 70. That would still give you a 70% profitable system, but you have to ask yourself, “Would you still be in the game if you lost 30 trades in a row?”
This is why money management is so important. No matter what system you use, you will eventually have a losing streak. Even professional poker players who make their living through poker go through horrible losing streaks, and yet they still end up profitable.
The reason is that the good poker players practice money management because they know that they will not win every tournament they play. Instead, they only risk a small percentage of their total bankroll so that they can survive those losing streaks.
This is what you must do as a trader. Only risk a small percentage of your “trading bankroll” so that you can survive your losing streaks. Remember that if you practice strict money management rules, you will become the casino and in the long run, “you will always win.”
Let me illustrate what happens when you use proper money management and when you don't...
Consider this example:
Let’s say you have a $100,000 and you lose $50,000. What percentage of your account have you lost? The answer is 50%. Simple enough. Now, what percentage of that $50,000 do you have to make in order to get back to your original $100,000? It’s not 50%--you’d have to make back 100% of your $50,000 to get back to your original $100,000. This is called drawdown. For this example, we would’ve had a 50% drawdown.
The point of that little illustration is that it is very easy to lose money and a lot harder to make it back. We know you’re saying to yourself, “I’m not going to lose 50% of my account in one trade.” Well we would certainly hope not!
However, what if you lost 3, 4, or even 10 trades in a row? That couldn’t possibly happen to you, right? (Sarcasm used) You have a trading system that wins 70% of the time, so there is NO way you could lose 10 trades in a row. (Even more sarcasm used)
Well, while you may have a good system, consider this example:
In trading, we are always looking for an edge. That is the whole reason why traders develop systems. A trading system that is 70% profitable sounds like a very good edge to have. But just because your trading system is 70% profitable, does that mean for every 100 trades you make, you will win 7 out of every 10?
Losing Streak
Not necessarily! How do you know which 70 out of those 100 trades will be winners?The answer is that you don’t. You could lose the first 30 trades in a row and win the remaining 70. That would still give you a 70% profitable system, but you have to ask yourself, “Would you still be in the game if you lost 30 trades in a row?”
This is why money management is so important. No matter what system you use, you will eventually have a losing streak. Even professional poker players who make their living through poker go through horrible losing streaks, and yet they still end up profitable.
The reason is that the good poker players practice money management because they know that they will not win every tournament they play. Instead, they only risk a small percentage of their total bankroll so that they can survive those losing streaks.
This is what you must do as a trader. Only risk a small percentage of your “trading bankroll” so that you can survive your losing streaks. Remember that if you practice strict money management rules, you will become the casino and in the long run, “you will always win.”
Let me illustrate what happens when you use proper money management and when you don't...
Don't Lose Your Shirt.
Here is a little illustration that will show you the difference between risking a small percentage of your capital compared to risking a higher percentage.
You can see that there is a big difference between risking 2% of your account compared to risking 10% of your account on a single trade. If you happened to go through a losing streak and lost only 19 trades in a row, you would’ve went from starting with $20,000 to having only $3,002 left if you risked 10% on each trade. You would’ve lost over 85% of your account! If you risked only 2% you would’ve still had $13,903 which is only a 30% loss of your total account.
Of course, the last thing we want to do is lose 19 trades in a row, but even if you only lost 5 trades in a row, look at the difference between risking 2% and 10%. If you risked 2% you would still have $18,447. If you risked 10% you would only have $13,122. That’s less than what you would’ve had even if you lost all 19 trades and risked only 2% of your account!
The point of this illustration is that you want to setup your MoneyManagement rules so that when you do have a drawdown period (losing streak) you will still have enough capital to stay in the game. Can you imagine if you lost 85% of your account? You would have to make 566% on what you are left with in order to get back to break even. Trust me, you do NOT want to be in that position. In fact, here is a chart that will illustrate what percentage you would have to make to breakeven if you were to lose a certain percentage of your account.
You can see that the more you lose, the harder it is to make it back to your original account size. This is all the more reason that you should do everything you can to protect your account.
So by now, I hope you have gotten it drilled in your head that you should only risk a small percentage of your account in each trade so that you can survive your losing streaks and also to avoid a large drawdown in your account. Remember, you want to be the casino…NOT the gambler!
Of course, the last thing we want to do is lose 19 trades in a row, but even if you only lost 5 trades in a row, look at the difference between risking 2% and 10%. If you risked 2% you would still have $18,447. If you risked 10% you would only have $13,122. That’s less than what you would’ve had even if you lost all 19 trades and risked only 2% of your account!
The point of this illustration is that you want to setup your MoneyManagement rules so that when you do have a drawdown period (losing streak) you will still have enough capital to stay in the game. Can you imagine if you lost 85% of your account? You would have to make 566% on what you are left with in order to get back to break even. Trust me, you do NOT want to be in that position. In fact, here is a chart that will illustrate what percentage you would have to make to breakeven if you were to lose a certain percentage of your account.
So by now, I hope you have gotten it drilled in your head that you should only risk a small percentage of your account in each trade so that you can survive your losing streaks and also to avoid a large drawdown in your account. Remember, you want to be the casino…NOT the gambler!
Risk To Reward.
Another way you can increase your chances of profitability is to trade when you have the potential to make 3 times more than you are risking. If you give yourself a 3:1 reward/risk ratio, you have a significantly greater chance of ending up profitable in the long run. Take a look at this chart as an example:
In this example, you can see that even if you only won 50% of your trades, you would still make a profit of $10,000. Just remember that whenever you trade with a good risk to reward ratio, your chances of being profitable are much greater even if you have a lower win percentage.
Summary of Money Management.
Be the casino, not the gambler! Remember, casinos are just very rich statisticians!
Drawdown is a reality and WILL happen to you at some point. The less you risk in a trade, the less your maximum drawdown will be.
The more you lose in your account, the harder it is to make it back to breakeven.
Trade only a small percentage of your account. The smaller the better. 3% or less is recommended.
It is desirable to trade when you have a high risk to reward ratio. The higher the ratio, the less you have to be right.
Drawdown is a reality and WILL happen to you at some point. The less you risk in a trade, the less your maximum drawdown will be.
The more you lose in your account, the harder it is to make it back to breakeven.
Trade only a small percentage of your account. The smaller the better. 3% or less is recommended.
It is desirable to trade when you have a high risk to reward ratio. The higher the ratio, the less you have to be right.
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