Five Tips For Successful Forex Money Management
Forex money management is something that many people overlook in their trading. Whether it is through lack of knowledge or idleness, traders who ignore money management do so at their detriment. This is one of the key factors that distinguishes a successful trader from an unsuccessful one.
But what is it exactly? Why is it so important? And how can you make sure you use it in your trading? In this article, we will provide answers to all these questions and more.
What is Forex Money Management?
Simply put, Forex money management is a set of self-imposed rules successful traders follow in order to manage their money effectively; minimising losses, maximising profits and growing the size of their trading account.
Forex money management is often, and understandably, confused with risk management, as they are fairly similar concepts. Risk management is more about identifying, analysing and quantifying all the risks associated with trading in order to manage them effectively and, in doing so, protect yourself from the downsides of trading. Money management just focuses on protecting your money.
An old trading adage helps to sum up the purpose of money management "cut your losses short and let your winners run". In other words, minimise loss, maximise gains and hopefully, by doing so, become a successful, profitable Forex trader.
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Top Tips For Successful Money Management
We know that, especially as a new trader, there is a lot to take in and learn when it comes to the Forex markets. Therefore, in order to make things easier for you, we have compiled a list of our top tips in order to help you come up with a successful system for your Forex money management.
Trade Only What You Can Afford to Lose
Our first tip, and probably the most important for any trader, is to only trade what you can afford to lose. As a beginner trader, you should only deposit what you can afford to trade with into your trading account and no more.
You might want to set yourself a maximum acceptable loss per month and if you hit that loss, stop trading. The idea is that you are only risking capital that will not drastically change your life if you lose it. Do not ever trade with the money you need for essentials; rent, mortgage payments, food, travel to work, etc.
Forex trading is not a guaranteed money maker. Some people will end their Forex trading career only having made losses. Do not risk what you cannot afford.
Quantify Your Risk per Trade
Once you have decided on an amount of money you are happy to trade with, you need to establish how much you are going to risk per trade and how you are going to measure this. This will help determine where you will place your stop loss for each trade.
There are two common ways of quantifying your risk, each with its advantages and disadvantages.
1. A Fixed Sum
Some traders set their maximum risk per trade as a fixed monetary amount. For example, a trader may deposit £10,000 into their trading account and establish that they will risk £500 per trade.
This is a very easy rule to follow. For each trade, regardless of what it is, you know exactly how much you are going to risk. If you make 10 trades a day, you know without doing much calculation, that the maximum you will risk is £5,000.
The disadvantage with this strategy is that it does not take into account any changes in your trading balance. If you go on a series of wins and grow your account substantially, but still stick to the same risk per trade, you could be missing out on greater returns.
On the other side of things, if you lose a lot of trades but your risk per trade remains £100, you are risking a higher proportion of your account balance, which could lead to your balance depreciating a lot more quickly.
2. A Fixed Percentage
The most common approach is to risk a fixed percentage of your account balance on each trade. Therefore, if a trader has an account balance of £10,000 and they decide they want to risk 2% of their capital per trade, the first trade would risk £200.
The benefit of utilising this method is that, unlike having a fixed sum, your risk per trade will fluctuate along with your account balance. In theory, if it is stuck to, you could never blow your account balance and when you are on a winning streak, your risk is increased in order to take advantage of the higher amount of capital at your disposal.
The disadvantage here is that, if you do sustain a series of losses, your risk per trade will get smaller and smaller along with your balance. This means that, if, and when, you start to win trades, it will take you longer to make back your capital.
Establish Your Risk to Reward
Now you know how much you intend to risk per trade, establish how much you are aiming to profit from that risk and use this to help place a take profit for your trades.
This choice will be dependent on your strategy and your trading profile, specifically your appetite for risk. A risk to reward ratio of 1:1 would mean, for example, that if your maximum acceptable loss is $100 your profit target would also be $100. A ratio of 1:3, however, for the same amount of risk would give a target profit of $300.
It is generally accepted that a risk to reward ratio should be higher than 1:1. This is because, if you won three trades in a row and then lost three trades in a row, and your risk to reward ratio was 1:1, you would have made a total profit of £0.
Whereas, if you were trading with a risk to reward ratio of 1:2, and you had three wins followed by three losses, because your profit was higher than the losses of each trade, you would still be in profit.
Depicted: Admiral Markets MetaTrader 5 - GBPUSD H1 Chart. Date Range: 6 November 2020 - 11 November 2020. Date Captured: 11 November 2020. Past performance is not necessarily an indication of future performance.
Leverage allows Forex traders to open larger positions than their capital would otherwise allow. Essentially, the trader borrows money from their broker to open a leveraged position. For example, if a trader has leverage of 1:20, they could open a position worth £10,000 with just £500 in their account.
This sounds like a great deal and, if used correctly, it can be incredibly helpful in becoming a profitable trader.
Because it allows you to access a larger position with less money, leverage can amplify the profit of a winning trade.
However, and this is important, leverage is a double edged sword. Those magnified profits on winning trades become magnified losses on losing trades. Therefore, it is important to use leverage with respect and care.
Something that many traders are guilty of is never withdrawing their profit, or not doing it regularly enough.
If you start to make a sizable amount of profit on your trading account - take it out, enjoy it, do something worthwhile with the money.
As we said at the beginning, part of Forex money management is maximising your profit. In order to do this, you need to look after your profit when there is one. The longer the money sits in your trading account, the more likely you are to trade with it and possibly lose it.
These five tips for successful Forex money management should stand you in good stead when starting up as a trader. Remember to stick to your rules once you have established exactly what they are. For example, you may decide to write down the something like the following as part of your overall trading plan:
- I will not risk more than 3% of my account balance on any one trade
- My preferred risk to reward ratio is 1:2 per trade
- My accumulated losses for the week will not exceed £2,000. If I reach this target, I will stop trading for the week
As with anything in life, the best way to perfect money management and Forex trading is by practicing. With Admiral Markets, you can do this on a demo account, absolutely free.
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This material does not contain and should not be construed as containing investment advice, investment recommendations, an offer of or solicitation for any transactions in financial instruments. Please note that such trading analysis is not a reliable indicator for any current or future performance, as circumstances may change over time. Before making any investment decisions, you should seek advice from independent financial advisors to ensure you understand the risks.