Money management is a way Forex trader control their money flow: literally IN or OUT of own pockets… Yes, it’s simply the knowledge and skills on managing own Forex account.
Forex brokers will rarely teach traders good money management skills, though almost all brokers will offer some sort of education, therefore it’s important to also learn on your own.
There are several rules of good money management:
- Risk only small percentage of a total account
Why is it so important?
The main idea of the whole trading process is to survive!
Survival is the first task, after which comes making the money.
One should clearly understand that good traders are, first of all, skillful survivors. Those who also have deep pockets can additionally sustain larger losses and continue trading under unfavorable conditions, because they are financially able to. For an ordinary trader, the skills of surviving become a vital “must know” requirement to keep own Forex trading accounts “alive” and be able to make profits on top.
Let’s take a look at the example that shows a difference between risking a small percentage of capital and risking a larger one. In the worst case scenario with ten losing trades in a row the trading account will suffer this much:
Apparently, there is a big difference between risking 2% and 10% of the account balance per trade. A trader who has made 10 trades risking only 2%, under the worst conditions would lose only 17% of his initial investment. The same trader who had been exposing 10% of the balance per trade would end up losing over 60% of his initial investment. As you can see, this simple decision — a money management approach — can have serious consequences if misjudged.
- Returning the lost capital is harder that it seems toLet’s take a look at calculations where a trader has lost some part of his account. How much effort will it take to recover the original account balance?
Now, here is a challenge: try on your demo account to gain a return of 300% or at least 100% of your original account trading as it were the real money. Will that be easy? I don’t think so. Can you prove me wrong?
3. Calculate risk / reward ratio before entering a trade
When chances to win in a trade are smaller than potential losses, don’t trade! Remember — staying aside is a position.
losing 40 pips versus winning 30 pips,
losing 20 pips versus winning 20 pips,
both examples are showing a bad risk management.
Before entering a trade, reassure that risk / reward ratio is at least 1:2 (but ideally 1:3 or higher), which means that chances to lose are tree times less than promises to win. For example: 30 pips of a possible loss versus 100 pips of a potential win is a good trade to consider taking.
Adopting this money management rule as a must, in the long run it will dramatically increase your chances to succeed in making stable profits.
Next chart shows the risk / reward rule in practice.
10 trades with 1:3 risk / reward ratio were conducted.
A trader was losing only $100 in a trade when he was wrong, but was winning $300 in each profitable trade.
As we can see, using 1:3 risk / reward ratio constantly and being successful only 50% of the time, anyone can make a profit in the end. The higher the reward ratio (compared to the risk ratio) the better are chances to end up in profit.
4. Learn to use protective stops
Continue reading about protective stops and their importance for good money management: Learn to use Stop Loss effectively.
5. A practical example of applying money management rules:
Risking no more than 2-3% of the total account per trade… How does it work in practice?
Let’s use an example to understand it.
We have opened a trading account of $1000 USD with a broker and got 20:1 leverage. So, now we have leveraged ourselves to $20 000 USD to begin trading with.
More money means a higher trading power. Correct. But, the higher the trading power, the higher the risks; and when we talk about risks we talk about a real account value which will decrease with every loss sustained during trading. So, when we say risking no more than 2-3% of a total account value we mean the real account value — which is $1000 USD in our case.
Now, let’s start trading and do the math.
Let’s say, we have decided to risk 2% of the account in each trade.
$1000 x 2% = $20 USD.
This means that when the price goes against us, we will need to be out of the trade once we are $20 dollars down. Ok, time to trade. Our trading power measures $20 000 USD (thanks to our leverage).
What will happen if we try to trade them all at once: for one $20 000-dollar trading lot order our Forex broker gives us a pip value of $2 dollars. This means that with each pip gained we will have +$2 USD in our pocket. But this also means that with each pip lost our real account will shrink by $2 dollars. Since we can afford to lose only $20 dollars in one trade, we’ll exiting a trade once the market makes… -10 pips! Yes, only 10 pips is required this time to reach our 2% limit. 10 pips * $2 USD per 1 pip = $20 dollars, which is our 2% account limit according with the money management rule we’ve chosen to follow.
Now, let’s try to trade a $10 000-dollar position. The pip value for this position size will be $1 USD.
The math goes as follows:
we can stay in trade until market makes -20 pips against us. Yes, this time we can sustain a bigger market shift.
If we decrease our trading lot to $5000 USD, our sustainability will raise to -40 pips against our trade. (The pip value for $5000-dollar lot will be $0.50 cents). And so on.
As you can see, with the money management rule in place our real account is under control. And even if leverage allows trading larger positions, the risks should be always under control.
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