One of the most important components of a successful trading plan consists of a comprehensive money management structure. Money and risk management make up two of the prime ingredients for success in the Forex trading. Even the best trading strategy in the world will fail to make you money in the long run without a solid money management plan.
Not paying attention to risk and money management can lead to unsustainable losses in a trading account. This can ultimately result in the complete loss of your funds, along with your trading confidence. We like to call it blowing your account.
Money Management in Forex Trading
The importance of a comprehensive money management component in a trading plan cannot be stressed enough. A person who begins trading without a trading plan and without a form of risk management is not trading but gambling instead.
A trader will typically have a clearly defined plan for both making money and for preserving their account by limiting their risk in the case of adverse market movements.
Money Management Principles
A number of important money management principles or rules would be strongly recommended for the trader to consider incorporating into their trading plan.
These principles might include the following:
- Trade with money you can afford to lose. The first major rule of thumb in money management is to avoid trading with money you cannot afford to lose. In other words, refrain from trading with your household’s mortgage, food money, taking on any sort of debt including overdrafts or making use of a credit card to fund your Forex account. Only use funds you can safely put at risk.
Essentially, placing money at risk which would otherwise be used for basic necessities can cause undue stress on just about anyone. As a result, this stress tends to affect the capacity of the trader to make sound market decisions.
- Position Sizing – Knowing exactly what percentage of the account is at risk at any given time is done through determining the size for each position that will be open, with only a certain percent of the account at risk on any open position.
Many successful traders tend to place only twenty percent of their account at risk at any given time. This allows for the trader to make back any money lost much more easily in the event of a string of losing trades.
Position sizing trades in an account with a clear strategy for making money, along with setting realistic goals for the expected returns on the account, usually makes a trader more efficient and profitable.
- Stop Losses – Determining how much the trader is willing to risk on any given trade should be followed up by placing a stop-loss order in the market at the level that this maximum tolerable loss would be incurred.
The stop-loss order would typically be entered immediately upon taking the position. This allows the trader to exit the trade automatically in the event they are mistaken on the direction of the market.
- Risk Reward Ratios – In addition to using stop loss orders and an appropriate position sizing technique, having an idea of how much you stand to make on each trade helps in setting exit levels and knowing when to liquidate positions.
Many successful traders use a minimum risk to reward ratio of 3:1 to screen out less profitable transactions. In other words, for every dollar placed at risk on the trade, they expect a potential return of three dollars.
Basically, you will want to manage your money when trading like any successful businessperson – based on a good plan. How much can you risk per trade without being fearful of losing the entire sum?
- Establish a Pain Threshold / What can You Afford to Lose? Even the most experienced trader has lost 4 trades in a row. Say you funded your trading account with R20000 and decided to risk a maximum of 2% of your account balance per trade, that amounts to an 8% loss of your trading equity or R1600 bucks. An 8% loss is totally fine with most Forex traders because they believe and trust their Forex trading strategy.
Now you lose a few more trades! How many more losing trades will you be able to handle before you start chasing your losses? I have done it personally when I started trading. You are now so far down and starting to ignore any trading rules you set yourself. Where you used to place a 2% of equity trade, all of a sudden becomes a 20% of equity trade in order to make up your losses quickly. Do look out for these situations. We are all different but the need to make your money back seems to be one of the root causes of blowing your trading account.