If you are trading currencies for a while, chances are that you have heard about money management pioneer Dr. Van K. Tharp. He is globally recognized as the most innovative and influential figure, when it comes to trading and position size management.
His book, “Trade Your Way to Financial Freedom” enclosed some of the ground breaking position sizing guidelines of the decade. Today, every other successful Forex traders around the world follow Dr. Tharp’s money management techniques by heart.
Although it may sound complicated at first, Dr. Tharp’s ideas are simple like most elegant things in the world. The main inspiration behind his technique is based around something that he called “Percent Risk Model” or PRM.
With PRM, a trader first need to identify his risk appetite in terms of what percentage of trading capital he is willing to risk per emerging trading opportunity.
The exquisiteness of percent risk model formulates around the simple idea that once you have decided your risk appetite based on a percentage of total equity, instead of a fixed dollar value, it aids in trading any amount of capital without chaotic equity growth and or decline curves.
With PRM, you can trade with as little as $100 or as big as $10 Million. Yet, you can formulate and apply same trading approach that your primary money management strategy and risk appetite approves of. This way a trader can grow his or her account gradually instead of arbitrarily risking his capital.
For example, let us assume a trader has $100,000 capital in his account and willing to risk 2% of his capital per trade based on the Percent Risk Model. Now, he would like to go short on EUR/USD at 1.2690 with a stop loss at 1.2750. In his reasoning, 1.2740 is a good resistance level and he would be giving 10 more pips as a grace space, just to be safe.
Using Percent Risk Model, he will calculate his position size by dividing his risked dollar amount by the number of pips in his stop loss. Hence, he will be risking (100,000 x 0.02) = $2,000 and his risk per pip will be (2,000 ÷ 60) = $33.33.
If another trader who choose to take the same trade but had only $1,000 capital in his account; then he would be risking only 33 cents per pip, right? In the end, both traders will be risking 2% of their total equity for the predefined profit they hoped that the trade will yield.
Dr. Tharp’s technique identifies that often traders lack the self-discipline to define their risks. Often traders will put too much weight onto a specific trade and take huge risks and vice-versa.
On the other hand, with Percent Risk Model, a trader will develop the money management discipline to stick to his risk appetite regardless how much equity he got in his account. This way the account will have with moderate risk for each trade and have a balanced and indomitable growth of equity over a length of time.