The foreign exchange market holds the remarkable position of being the world’s largest financial market. Prior to the advent of online forex brokers that brought forex trading to the masses, this huge market had largely been the trading domain of large financial institutions, corporations and high net worth individuals.
As interest in the currency market has quite recently expanded into the retail sector, the need for educating novice traders on the use of appropriate risk and money management tactics has also grown substantially. The benefits of learning about and applying the well-established methods of protecting one’s trading capital are considerable since they can really make the difference between a successful forex trader and one that quickly sees their trading account funds disappear.
The proper application of money management gives a forex trader an account growth edge, while trading forex without a logical money management strategy typically amounts to little more than gambling. This explains why forex risk and money management practices remain an essential part of the business that needs to be incorporated into every forex trading plan. In fact, the main reason why novice forex traders fail to grow their trading accounts is due to their lack of understanding or failure to apply proven money management principles to their trading endeavors.
Accordingly, proper risk and money management techniques need to be understood and consistently practiced by any forex trader who wants to grow their trading account and remain in the currency trading business over the long term. The following sections of this article will introduce basic money and risk management concepts. They will also discuss some of the more popular techniques for managing risk and money when trading currencies, as well as some of the tools traders commonly employ when doing so.
Introduction to Risk and Money Management
For forex traders, the goal of money management is to maximize profitability and minimize losses while conserving trading capital, while the overall purpose of risk management is to make sure that various uncertain elements in the trading environment do not derail their chances of profitability and other measures of success in their currency trading business.
Risk management in forex trading is a rather broad concept. In essence, forex risk management involves identifying, assessing and prioritizing currency trading risks and then engaging in the use of resources to minimize, control and monitor the chances and/or effect of adverse events, such as trading losses, and to maximize the chances and/or effect of favorable events, such as trading gains.
Money management in trading currencies should be a key part of a forex trader’s overall risk management strategy. As the name implies, forex money management involves consistently using one or more strategic techniques to make a currency trader’s risk capital yield the highest return for any losses that might be incurred in the process. Money management revolves around the basic idea of conserving trading capital or money by effectively managing the numerous financial risks your forex trading account is exposed to.
Money Management in Forex Trading
Trading successfully in the forex market typically means growing your trading account by wisely managing profits and losses using a sound forex money management strategy. Although wisdom typically grows with experience, most currency traders would tend to agree that profits taken should typically be larger than losses taken, which is the essence of the old adage that advises traders to “cut losses short and let profits run”.
Ideally, every forex trader looking to grow their trading account should be using a forex money management system contained within a trading plan that objectively lays out their goals and how they intend to manage their trading activities. Of course, the actual details of each trading plan will differ according to each individual trader’s personality, choices and preferences, but every such trading plan should lay out the money management techniques the trader creating it intends to use.
Although some common money management techniques might limit the profits a trade might potentially make, their use as part of an overall money management plan are some of the best practices a forex trader can employ to remain consistently profitable overall. After all, the forex market can be quite volatile at times, so having a detailed set of forex money management rules allow you to know in advance how you intend to size a position, limit losses and take profits.
Forex Money Management Rules
Incorporating money management techniques into your trading plan might take a bit of trial and error to see what works best for your trading strategy, account size and risk tolerance. Of course, any trading plan is only as good as the discipline a trader can muster in sticking to it. Quite simply, you should make sure you plan the trade, and trade the plan.
As a good place to start, some of the more established guidelines for money management include the following:
- Trade only with funds you can afford to lose. Since traders usually become emotionally stressed by losing money they require for the essentials of life — such as food, shelter or any other necessity that requires money — the best rule of thumb is to only trade with risk capital. This means only trade with money you can safely put at the risk of losing completely, since forex trading can result in the total loss of your trading account. This key money management principle will help you be less emotionally strained by losses sustained in your trading account and will allow you to exercise better judgment and think more strategically, which should benefit your overall trading performance considerably.
- Assess risk reward ratios before trading. Before pulling the trigger on any trade, you really need to determine what reward you think the trade might reasonably be expected to achieve and what risk you are willing to take in order to obtain that reward. Suitable risk reward ratios to trigger trading can differ among traders with varying risk tolerances and trade criteria, and they will typically be included in a comprehensive trading plan. As an example, some active traders might use a risk reward ratio of 1:2. This means that they are willing to risk one unit of loss in order to make the two units of profit they are anticipating from the trade. On the other hand, more conservative traders might wait to execute a transaction until they determine a potential trade has a 1:3 risk reward ratio. The basic idea in setting a suitable risk reward ratio to use when trading is to filter out less attractive trades in order to only expose your trading account capital when better opportunities arise.
- Choose a suitable position size. Traders need to set strict guidelines for the suitable amount to be traded given their account size. This helps protect the existing funds in their account from unanticipated trading losses. Some traders prefer to determine their trade amounts as a percentage relative to the amount of funds remaining in their trading account in order to conserve capital. Others traders might use the expected risk reward ratio on a trade to determine what size of a position they should take, with those trades for which they expect a greater reward for a given risk unit being taken in larger amounts. Still other traders might trade in a fixed amount or number of lots. All of these position sizing strategies can be used effectively to manage your money when trading forex, so choose one and apply it consistently.
- Avoid risking all your capital at any given time. Many traders prefer to keep a large portion of their trading account funds in reserve so that they can recover faster from any significant losses, rather than putting all of their trading capital at risk at once. For example, a trader might avoid putting more than ten percent of their trading capital at risk at any one time across all their open positions. Thus, even if they suffer a full ten percent drawdown on the funds placed at risk, they still the remaining ninety percent of funds in the trading account. Putting a substantially large percentage of their account at risk might make fund recovery in the case of loss virtually impossible, or at least impractical, thereby effectively putting the trader out of business.
- Know when to exit the trade before you enter a trade. The analysis performed before entering into a trade should give the trader a clear idea of where they expect the market to move to so that they can take profits on the trade, in addition to where they would cut their losses in the event of an adverse market move. This key pre-trade analysis will allow the trader to set appropriate take profit and stop loss orders for each trade when they are in a more objective state of mind. This important trade planning stage can really help traders avoid the lack of discipline when the time comes to either reap the rewards or take the losses as a consequence of their trading decision. Some traders might also set a time limit on their trades, so that the trade is closed out if the market does not perform as expected within a particular time frame. All of these decisions should be made ahead of time so that they can then be followed objectively rather than being influenced by the potentially problematic emotional states that commonly occur among traders when faced with decisions around trade management.
Money Management Tools
Many forex traders who have incorporated some or all of the best money management practices listed above into their trading plans will use or develop various money management tools to help them compute positions sizes and risk for each potential trade they plan to take.
Although some online forex money management calculators are available, traders who are familiar with the use of Microsoft’s Excel or another similar spreadsheet program can readily create their own software tools for this purpose and can customize them to their specific trading needs.
For example, a typical money management calculator you can easily create in a spreadsheet might help you to determine what position size to take in a particular currency pair based on the amount of funds in your account and the amount of money or percent of your account you want to risk on the trade.
A money management tool like this might have the following parameters as inputs:
- your total portfolio size,
- which currency it is denominated in,
- how much or what percentage you wish to put at risk
- the currency pair you wish to trade
- whether you want to buy or sell the currency pair
- your proposed trade opening rate, stop loss rate and take profit rate
The outputs of the calculator could then include the position size you should take, as well as the number of pips you are risking and anticipating as profit on the trade and what that means in terms of profit or loss to your trading account expressed in your base currency.
Additional Forex Risk Management Considerations
When trading currencies, risk management involves identifying potential risks, assessing the probabilities of them occurring, and then taking steps to avoid them. Risk management might also include mitigating any damage to your trading account, ability to trade, lifestyle and relationships if an anticipated risk eventually becomes a reality.
The various money management strategies discussed above are an important element of risk management that focus largely on possible market movements, position sizing and their potential trading account impact. Nevertheless, not all of a trader’s risk management strategies will be solely related to market or account risk, since various other types of risk can impact a forex trader’s overall business.
For this reason, traders will often incorporate some additional risk management strategies into their forex trading plan. Some additional components of trading related risk and how to manage them into a forex trading plan appear below:
- Avoid adverse lifestyle impacts. Trading forex can be exciting and can even become addictive due to its round-the-clock availability. This can result in sleep loss, stress, eye strain, antisocial behavior and other adverse changes to your lifestyle. Remember to make sure that your trading business is enhancing your life rather than degrading it
- Relieve excessive trading stress. Trading currencies can be stressful, especially when losses need to be taken, and this can lead to severe health and psychological issues arising. Make sure your trading plan suits your personality type, and be sure to take time away from the market to relax and unwind.
- Watch for adverse regulatory changes. Keep yourself informed about laws and policies in your local jurisdiction and watch for future regulatory adjustments to forex related activities that could negatively affect your trading business.
- Plan ahead for financing issues. If the funds in your trading account may be needed for some future event — such as a home deposit, child’s education, or their return to a financial backer — make sure you have an alternative source of funding for your trading account lined up.
- Have a good computer and a backup Internet connection. If you intend to use an online forex broker for trading currencies, you will need a fairly modern computer and a dependable Internet connection. If you are routinely placing large amounts of money at risk while trading, it also probably makes sense to have a backup computer and Internet connection, just in case your primary systems go down at an inconvenient moment while you are trading.
- Use a reliable forex broker. A lot of forex traders have found their online brokers to be unreliable and perhaps even fraudulent. Carefully check out a potential broker’s reputation before funding an account with real money, and watch out for slippage and re-quotes in fast markets while testing a new broker using a demo account.
- Beware of broker fee changes. If your forex broker decides to change their fee or trade commission structure, it could have a negative impact on your trading business, especially if you are trading large volumes frequently. Review your broker’s fee structure and charges periodically to make sure they remain stable and suitable for your trading style.
In conclusion, the various risks involved in running a forex trading business need to be monitored, managed and mitigated. Research shows that having a suitable forex risk management plan that includes sound money management practices can greatly increase your chances of becoming a successful forex trader over the long term.