You can have the best trading strategy in the world, but without good forex money management practices you’ll most likely end up in the negative territory. We can even argue that the main difference between a winning and losing trader is not the strategy they utilize, but rather the way they deal and manage with open positions, unprofitable trades and stop-losses – that is, how strictly they follow the best practices of money management.
Emotions have a big impact on the way we trade, and many traders don’t exit quickly enough from a losing trade and hope instead that it will turn profitable again. This mixture of fear and greed is what ultimately separates the bottom line of professional traders from that of amateurs, and its negative impact can be prevented by learning the basics of money management in forex trading.
Why is Forex Money Management So Important
Good money management is what dictates the profitability of a trader. A professional trader that respects his money management rules will be profitable even with a mediocre trading strategy, while even the “holy grail” won’t help an amateur trader who doesn’t follow the basic rules of money management.
As you can see from the following table, the more of your be to recover from the losses.
While a trader would need to earn 33% to break even after a 25% loss, the same trader would need to double his account after a 50% loss in equity! To avoid such terrifying situations, you should follow your money management rules and strictly abide by them.
The Golden Rule of Money Management
The Golden rule in money management is never to risk more than 2% of your trading account on a single trade, and never risk more than 5% of your trading account on all trades combined. If you’re new to trading, you should set your risk per trade even lower, to around 1%. This will make sure that one or a few losing trades in a row will not wipe your entire trading account out.
Let’s say you have a trading account of $10,000. Following this rule to determine your risk per trade, you should never risk more than $200 on a single trade, which equals to 2% of your trading account ($100 if you’re a beginner). However, to avoid your stop-loss to be hit too soon due to usual price fluctuations, you’ll need to make sure the market has enough room to breathe. Let’s see how to determine the size of your stop-loss, as well as your position size, in order to still be on the safe side of money management.
How to Use Stops in Forex Money Management
There are four main types of stop-loss orders:
- Equity Stop – based on a percentage of your account
- Chart Stop – based on price action and support/resistance levels
- Volatility Stop – based on average price volatility over a period of time
- Time Stop – based on a predetermined period of time, such as by end of trading day, trading week etc.
Out of all these stop-losses, a chart stop will give the best long-term results. You should never place your stop just based on a percentage of your account, price volatility or a period of time. That being said, the percentage of your account that you’re going to risk per trade, will ultimately affect the position size that you’re able to take based on the size of your chart stop. Sounds complicating? Let’s give an example.
Taking the example above, the size of your trading account is $10,000 and you want to risk a maximum of 2% of your account, that is $200. All further calculations will be based on this amount – the amount you’re willing to risk. You should also note all this information in a spreadsheet or trading journal, which can also calculate all the values automatically for you.
Next, your favorite currency pair is trading inside an upward channel, and you think it’s the perfect time to enter a long position after the price touches the lower channel. You determine that your chart stop should be placed just below the previous swing low, which equals to 50 pips.
In order to calculate your position size, simply divide your $ risk-per-trade with your stop-loss ($200 / 50 pips = $4 per pip). This is the maximum position size you should take, $4 per pip or around 0.4 standard lots (depending on your base currency). Let’s add this information to our little money management table.
To risk 2% of a $10,000 trading account on a trade with an appropriate stop-loss of 50 pips, your position size should be around 0.4 lots, or $4 per pip. Remember, your trading account size, % risk per trade and stop-loss (pips) are all together determining the position size you should take!
Forex money management is the single most important factor that determines your long-term success in the forex market. Many traders have difficulties with sticking to a solid forex money management plan, which is one of the main reasons why so many traders are unprofitable in this market. Having a solid trading strategy is just one side of the coin, while the ability to effectively manage your risk of open trades is what will make you a profitable trader.
All professional traders are paying attention to their money management, tweaking it from time to time to get the best possible results. By respecting the simple rules provided in this article, you are protecting your trading account and reducing your risks associated with forex trading.