Money management is a key element for a successful forex trading experience. However, it is often overlooked by many active traders, not only newbies. Good money management is one of few factors that really distinguishes successful traders from unsuccessful ones. Money management has a magnificent role when it comes to trading. Without proper money management tactics, trading would be almost gambling. Every profitable trading strategy is based on convenient money management rules and a solid risk management plan.
What is Money Management in Forex?
Money management refers to a set of practices and predefined rules to follow in order to manage money more effectively, increase profitability, minimize losses and make the most out of the trading account. Traders apply money management techniques to keep track of the trading performance and achieve constant profits.
Rules of money management should be an essential factor in a well-developed trading plan. Understanding money management and strictly following self-imposed rules can make all the difference to your forex trading performance.
Why is Money Management Important?
In the Forex market, it is not always about anticipating future prices. Being a successful trader depends on your commitment to your rules. Even the best trading strategy won’t help much in making your trading successful if you don’t apply proper money management rules.
Most forex beginners don’t pay attention to money management as they are more focused on getting into the best out of trading. So, they tend to open many and large positions which usually blow their first trading account in a short time. Sometimes traders start to think of money management when they fail more than once. That is a common mistake made by many. In fact, starting your trading journey correctly by controlling your potential losses and trading risks plays such an important role in trading.
Top 10 Money Management Tips for Forex Trading
Cut Your Losses Short and Let Your Profits Run
It is basically the main tip in money management. It is a rule that is commonly followed by professional forex traders. When they have a winning position, they keep it running. On the other hand, they are impatient with the losing positions, they cut their losses early and exit the losing trades. Ironically, beginners do the exact opposite of this rule. They keep their losing trades running hoping that they will revert in their favor, and cut their profits short as they fear missing out on the profits.
Always Use a Stop Loss Order
The forex market is highly unpredictable especially when it comes to price volatility. That’s why using a stop loss order will help you minimize losses as possible if the market goes in the other direction. It is an essential rule in both money and risk management. A Stop Loss order is used to automatically close a trade when the price reaches your set price level. It is usually placed with a market order or a pending order.
Lock Your Profits
Another common technique is locking your profits. One way to do this is by using a trailing stop. A trailing stop is a type of stop-loss that secures profits as long as the market moves in the trade’s direction, and automatically closes the trade if the market moves against it. This order follows the market price until it moves against your position. For example, if you are trading in a strong market trend, it is wise to use a trailing stop to constantly lock your profit before the market reverses against your trade.
You don’t have to chase every opportunity in the market. Remember that discipline and patience are the keys to successful and profitable trading. Make sure that every position you open is based on market analysis. Overtrading won’t get you anyway far from maximizing your risk exposure.
Another important concept in money management is the reward-to-risk ratio or R/R ratio. This ratio measures the potential profit on trade compared to the potential loss. If you keep your losses limited and practice money management in a smart way, you will be able to stay in the market for a long time. By setting this ratio, you can identify how much money you will risk per trade. By exceeding that amount, you are violating your own rules. Try to stick to the 1% common risk rate per trade. You can also consider a proper risk-to-reward ratio of 1:2 or 1:3, meaning that potential profit should be triple or at least double the potential loss on the trade.
Trade Only What You Can Afford to Lose
The next tip and probably the most important for traders, is trading only what you can afford to lose. If you are a beginner, you should never trade with more than you can afford. This rule is commonly overlooked by ambitious traders, making it on top of the most broken rules of money management ever. That’s because traders usually get tempted by the possible profits they can make, ignoring how much they’re risking.
Set a Maximum Drawdown
The drawdown is the difference between the highs and lows in the balance of your trading account. It measures the lost capital in your losing trades. The drawdown level may vary according to the strategy being followed. Let’s say a trader tests a strategy over 100 trades, with only an 8% drawdown. Then the max level here will be 8%. When trading live and the drawdown exceeds this level, the trader should interfere and close some or all the losing trades to keep the account on track.
Never Trade with Emotions
Trading in the forex market can trigger different overwhelming emotions like greed, anger, anxiety, or even fear. If you fail to get your emotions under control, you won’t be able to make good trading decisions, leading to losses. And as Warren Buffett once said: “If you cannot control your emotions, you can’t control your money.” Never make trading decisions based solely on how you feel. Develop a solid trading plan, set your money management rules, and strictly follow a proper risk management strategy. This will help you develop a stable trading psychology, make good trading decisions and will keep you away from emotional trading.
Calculate Your Position Size
Position size is crucial in money management, as it measures the potential profit. Determining the proper lot size will depend on your risk tolerance and account size. Calculating how much money you are putting at risk per trade heavily relies on the lot size. For example, using large lots on small accounts may cause instant money loss. Learn How to Calculate the Proper Position Size.
Use Leverage Wisely
Forex leverage is borrowed capital to maximize an investment’s potential return. It also gives traders the ability to increase the trading capital with a relatively small deposit, the margin. Despite its various advantages, it entails huge risks if not applied properly. High leverage may seem highly tempting as it magnifies the investment capital and potential profits, but what is always being overlooked is that it magnifies the possible losses as well. It is advised to choose the proper leverage level according to your experience, capital, goals, and risk tolerance.
Money Management Vs. Risk Management
Both money management and risk management are designed to protect the trader’s funds, but each has its different approach. Some investors confuse money management with risk management despite the differences between the two of them. Money management is more focused on protecting the trading capital while risk management is identifying potential risks. Risk management is a tactic used to identify potential risks to the investment in advance, analyze them, and take precautionary steps to avoid their impact.
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