Money management is a critical component to successful Forex trading that many traders either ignore or simply don’t fully understand. Speculative Forex trading is inherently risky; there is real and present danger that you could lose money on any given trade you enter into, so practicing proper Forex money management is essential to long-term trading success. That being said, it is pretty obvious that most traders do not practice proper money management because we have all heard the statistic that something like 90% of trader’s fail to make money over the long-run in the Forex market. This blog post is geared towards helping struggling Forex traders understand the importance of proper money management as well as supplying them with some concrete tips they can implement immediately to practice proper money management.
Trade only with true risk capital
If you begin your Forex trading career using money that you really cannot afford to lose or that would be put to a better use elsewhere in your life, you are basically carving your own trading tombstone. Many traders start trading with money they really should be using to pay down debts or that they could be using for retirement savings or other life-necessities. The only money you should ever use to trade the market with is money that is true risk capital; meaning money that you do not need for any life necessities or long-term savings. Essentially risk capital is “fun” money; money you would likely just have spent on things you don’t really need, this is the type of disposable capital you should fund your trading account with. If you start trading with any money other than that which is truly available risk capital, you dramatically increase the chances of becoming an emotional trader, because you will feel pressure to not lose your trading money and to make it grow very quickly. If you don’t have enough disposable capital to trade with a live account with than don’t trade until you do.
Demo trade before risking real money
No matter what you may have heard or read on the internet, demo trading is critical to long-term Forex trading success. There is simply no way to know how the particular Forex strategy you are going to use actually works if you do not demo trade with it before going live. If you choose to begin live trading before fully mastering your trading strategy, you are going to fall prey to many silly mistakes that could have otherwise been avoided had you just demo traded first. Many traders want to start making money immediately when they first get interested in Forex trading, unfortunately this is not how it works, just like any other profession you have to pay your dues and put in the necessary time and effort to get good at the art and skill of trading. Patience is one of the biggest keys to success for a trader, by committing at least 2-3 months to mastering your strategy on a demo account you will be helping to foster the very positive trait of patience as a result of not jumping into live trading head first. A solid habit of patience will reward you many times over throughout your Forex trading career.
Consider yourself a risk manager rather than a trader
As a trader, your main goal needs to be to effectively and efficiently manage your risk on every trade and to begin viewing and weighing each trade setup in terms of possible risk to possible reward. Always define your risk before entering a trade and make sure you can sleep soundly at night with the amount of money you have at risk. Most traders think about the market in an opposite manner; they view the market as an endless supply of money, basically they view it as an ATM and they severely downplay the risk involved on every trade. Ask any professional Forex trader what their overall winning percentage is since they started trading full-time and you are likely to hear around 50%. The reason professional traders can lose on half their trades and still make money is because they figure out long ago that they need to view the market in terms of risk and not so much in terms of reward. If you concert on managing and maintaining your risk below the level that invokes an emotional response within you, the reward side of trading will take care of itself. Learn to concentrate more on the risk for every trade setup you take and the reward aspect will essentially take care of itself.
Obtain a clear understanding of position sizing before going live
Position sizing is the means to carrying out proper forex money management. Understanding position sizing in forex trading is critical to maintaining objective thinking and clarity while trading the market as well as correctly managing your risk. To correctly implement position sizing in the forex market you need to first pre-define the amount of money you are truly OK with losing on one trade before you do anything else. Once you have this figure defined you then wait patiently for a high probability trade signal like a price action setup, once your desired setup forms in the market you then need to start thinking about risk, not reward just yet. Most traders do the opposite at this point; the immediately try to figure out how much money they can squeeze out of a given trade setup before paying any attention to stop placement or risk.
Stop placement and risk is the next thing you need to think about after finding a high probability trade setup. This is where position sizing comes in; you need to find the safest place for your stop loss so that it gives the trade the best chance of working out, after you determine this level you must then calculate the correct position size, or number of lots you will trade so that your previously pre-defined risk amount is not increased or decreased. Many traders do not do this correctly however; they either put too small of a stop loss on the trade because they want to increase the number of lots they are trading out of greed, or they put a really large stop loss on the trade and do not adjust down their position size to maintain their risk; effectively, they dangerously increase their risk by doing either of these. Forex trading is a test of self-discipline and controlling one’s impulses of fear and greed, the degree to which you correctly implement position sizing and risk management will be the degree to which you correctly manage your emotions and achieve your goals in the market.
Learn to take profits at logical intervals as they are available
After you have defined your risk on a trade and correctly implemented position sizing, you can then think about reward and where to take it. Many traders mess this up by hoping for some ridiculously big profit target that is 1,000 pips away and that will take months to get hit, if it gets hit at all. The bottom line is that most new Forex traders are starting with relatively small sums of money in their accounts and so it is critical that they begin building their accounts up by taking smaller profits as they present themselves, instead of holding out for that big winner that is a lot less likely to come. There is simply nothing wrong with taking a reward that is 2 times your risk on any trade, or even 1.5 times your risk.
If you take 1:2 risk reward trades, you can lose on over half of your trades and still make money, if you take 1:3 or 1:4 rewards you can win on far less than 50% of your trades and still make money. Many traders fail to take profits at logical intervals like this and as a result they never make any money. If a trade keeps going in your favor after you take a 1:2 winner, there really is no reason to care. You made money on the trade and you at least doubled your risk, this is all that should matter because there will always be tomorrow and there will always be excellent opportunities in the Forex market. This is where patience comes in like we mentioned earlier; you can’t feel rushed to make a ton of money in the market if you are starting with a relatively small trading account. Don’t let greed or fear influence your exit strategy by predefining your reward target at reasonable and logical multiples of your risk.