A well-defined Forex trading money management system is just as important for how to be a successful trader, as a good forex trading strategy.
What is Forex money management?
Forex money management is a set of processes that a forex trader will use to manage the money in their forex trading account.
The underlying principle of forex money management is to PRESERVE TRADING CAPITAL. That doesn’t mean never having losing trades in forex because that is impossible. Forex money management aims to minimise trading losses so that they are ‘manageable’. That means when a trade turns to a loss, it does not prevent the trader from winning other trades.
The idea of money management is closely linked to risk management because when trading, all the risks portend to your money. However, the definitions are slightly different. Risk management is about preparing for and managing all identifiable risks - that can include things as arbitrary as having a backup computer or internet connection. Whereas money management for forex traders relates entirely on how to use your money to grow your account balance without putting it at undue risk.
How do I stop losing money in forex?
This the question that forex money management will help to answer. Since we are all human and tend to have similar traits (good and bad) there are common mistakes to avoid in forex trading. Successful traders tend to think of trading as a business. The aim of your forex trading business is to make money, not lose it so steps should be taken to avoid losing it.
Can you lose all your money in forex? Yes, you can lose all your money in any investment where your funds are put at risk. So it is your job as an investor to minimise the chance that happens.
There are ways to fine tune a trading strategy to win more and lose less, but that is not normally the main reason people lose money in forex. The main reason tends to be having no specific money management rules to follow. So we will go through those rules now.
Top forex money management rules to follow
If you get these five money management rules right, your odds of forex trading success will improve greatly. These rules can be tailored to your own trading system but some version of these five forex money management rules should be written down and read before every single trade is placed.
1. Defining risk per trade using position sizing
The idea is that a trader should risk only a small percentage of their account on any one trade. Trading mentors often preach the ‘2% rule’ where a trader should risk 2% of their account on every trade.
For example, with a 100,000 CHF trading account, the trader would risk 2,000 CHF per trade.
Some traders will vary the size of each trade, depending on recent trading performance. For example, the anti-martingale money management method halves the size of the trade each time their is a trading loss and doubles it every time their is a gain.
A top trading strategy and sound risk management plan should help a trader make money over time, but you can never be sure what will happen in the next trade or even the next 10 trades. To mitigate the risk of the next trade being a loss, the forex trader should keep the trade size relatively small compared to the size of the trading account.
Then taking this same principal and extending it, the trader should also protect themselves against several losing trades in a row by making the amount risked so small that even ten losing trades in a row will be something they can quickly recover from.
2. Set a maximum account drawdown across all trades
What is a drawdown in forex? A drawdown is the difference in account value from the highest the account has been over a certain period and the account value after some losing trades. For example, if a trader has 10,000 CHF in their account, and then loses 500 CHF, that is a 5% drawdown. (500 is 5% of 10,000). The larger the drawdown, the harder it is to recover the account balance with winning trades.
Traders will set a max drawdown level that is acceptable according to their trading strategy backtesting. For example, if a trader tests their strategy over 50 trades and only ever experienced a 6% drawdown, then the trader might set 6 or 7% as the max drawdown. If when trading a live account, all the open trades put the account down by over 7%, the trader would have a money management rule to close some or all the trades to put the account back into good order.
3. Assign a risk: reward ratio to every trade
Is 2:1 risk reward the best? The rule of thumb taught in trading textbooks is that a trader should aim to have winning trades that are on average twice as big as the losing trades. With this risk: reward ratio, the trader need win only a third of their trades to breakeven.
In actual fact, the most important thing is to be consistent in the risk: reward ratios chosen. If a trader chose a risk: reward ratio of 1:1, then the trader must win a higher number of trades (at least 6 out 10) trades to be profitable. If the trader chooses a risk: reward ratio of 3:1, then they need to win fewer trades (1 in every 4 trades) to break even.
How to be a consistent forex trader… To achieve long-term profitable forex trading, a trader must have some idea what to expect from his or her trading strategy. Two important and complimentary components of that are the win: loss ratio and risk: reward ratio.
4. Use a stop loss and take profit order to plan trade exit
Using a stop losses locks in the maximum amount a trader can lose in any one trade, while using a take profit order locks in the maximum amount the trader can win. Using these forex order types the trader can make sure that he/she is not unexpectedly in a position that loses more money than planned.
Of course there are some disadvantages to using stop losses, the most frustrating of which is seeing a stop loss triggered, only for the trade turn around and hit the take profit level. But as annoying as that experience might be, it is worth keeping a stop loss to avoid those occasions when the price does not turn around quickly and leaves the account with an unmanageable loss.
5. Only trade with funds you can afford to lose
Last but not least; successful trading is only possible when the trader can make unemotional decisions about what do with a trading opportunity. If the trader ‘needs’ the trade to win because the money is required for other purposes, the trader is liable to make bad decisions and increase the odds of losing money. “Hope for the best and plan for the worse” by trading with funds that would not hurt your lifestyle if you lost them.
Can I trade forex with $100?
Let’s finish this forex trading presentation by answering this common question from newbie traders, particularly younger investors who have a small amount of money but would like to get started trading forex anyway.
Yes, it is possible to trade with $100 but it will be harder and a solid money management approach becomes even more important. In this instance, the trader should use ‘micro lots’ where each trade is worth around $1000 and each pip is worth around $0.10. Then the trader must have a maximum stop loss of 20 pips, worth $2 to keep to the 2% rule for positioning sizing. If you have more money to trade, it provides you with more room to manoeuvre in your trades and adds flexibility to your money management rules that increase the odds of being a profitable trader.