Ask any trader who is successful in the long run about the single most important factor in trading, and the majority of them will tell it’s a strict way of managing your money and risk. Even the best strategy in the world won’t be of much help if you don’t take care about your risk per trade, reward-to-risk ratios, don’t use stop-loss orders or trade too aggressively. That’s why we decided to cover the main aspects of money management in this article, to help you become and stay a successful trader in the forex market.
1. Know Your Risk Per Trade
As it name implies, the risk per trade is the amount of your trading account that you’re ready to risk on a single trade. It’s a key aspect of prudent money management that prevents you from blowing your account on a series of losing trades. Many money management techniques state that the upper limit of your risk per trade should be 2% of your trading account, or even less if you’re a beginner in the markets.
Your risk per trade will also determine your overall position size per trade. Let’s say the size of your trading account is $10,000, and you’ve spotted a promising trade setup with an appropriate stop-loss of 50 pips.
Knowing that your maximal risk per trade is 2% of your account, i.e. $200, it’s easy to calculate your appropriate position size for that trade. Simply divide your capital at risk with the stop-loss in pips. This calculation returns your dollar value per pip of $4, or cca. 0.4 lots ($200 / 50 pips = $4).
2. Always Use Stop Losses
A stop-loss order is the only guarantee that you won’t lose a substantial amount of money on a single trade. Although certain market conditions can lead to your stop-loss order not being executed at the set price, most of the time they work just well to prevent losing your entire account on a few trades.
Whether you use time stops, volatility stops, or chart stops, always make sure that your stop-loss level represents a target based on actual price-action and market conditions. This includes placing your stops around support and resistance levels, trendlines, channels, chart patterns, as well as considering the volatility of the pair to let the price enough room to breathe. Never place your stops based on imaginary percentage or pip amounts.
3. Consider Reward-To-Risk Ratios of Trades
Beside having a clear stop target for your trade, you should also know where to close your position in advance once it gets profitable. Placing inappropriate take-profit levels can be as damaging to your trading results as placing inappropriate stop levels, as you won’t be able to maximize the profit potential of your trade setup.
Your take-profit level also determines the reward-to-risk ratio of your trade, which simply represents the amount of your risk relative to the potential profit of the trade. While R/R ratios of 1:1 mean that you’re risking the same amount as your potential gain, trades with R/R ratios of 2:1 or 3:1 have double or triple the amount of potential gain relative to the risk.
In other words, while it will take you the same amount of winning and losing trades with R/R ratios of 1:1 to be break-even, you can have two losing trades and only one winning trade with an R/R of 3:1 and still be profitable.
4. Use Leverage Wisely
Many traders are attracted to the forex market in the first place because of the tremendous leverage that is offered by forex brokers. Although leverage is necessary in the forex market as many currency pairs usually move less than 1% per day, traders need to understand that a higher leverage also increases the potential loss per trade.
As said earlier, always determine your position size and leverage based on the stop-loss in pips, in order to avoid large losses.
5. Don’t Trade Based on Emotions
This is where many novice traders have difficulties with. Moving stop-losses once a trade is already open, exiting early from a profitable trade or simply using too much leverage to increase potential profits are usual mistakes that happen once traders let emotions manage their trades. If you do your analysis right, have confidence in your entry and exit levels and let the market determine if you were right or wrong.
Having a strict and written trading plan that contains not only your trading strategy, but also the way you manage money and risk, can help you to avoid emotional trading.
6. Keep a Trading Journal and Learn Along the Way
Keeping a trading journal will help you to identify your weak spots of money management. Analyze your journal entries regularly and identify recurring patterns that lead you to lose money. Are your stop-losses too tight or take-profits too far away, reward-to-risk ratios inappropriate or risk per trades too large? This will help you fine-tune your money management techniques and become more successful in the future.
Tradings Most Important Technique to Master
Money management is perhaps the most important technique traders need to understand when trading the forex market. Although money management is a wide and flexible topic, the mentioned points in this article give you an overview of the basics you need to be aware of as a forex trader. These points alone will already give you a significant trading edge over the majority of forex traders who struggle to become profitable in this market.