Money management is an important aspect of forex trading. However, many traders are led astray by some beliefs that turn out to be only myths. What are they? Let's check some facts in this article.

Trading is a business, and when there is a business, there is a risk. Regardless of the size of our capital, we certainly would want to limit our potential risk. Understanding proper risk management is the key to consistently generate profits in the long term. That being said, there are many myths when it comes to money management in forex trading. If taken seriously, the myths can hinder our progression instead of helping our growth.

Money Management: Debunking the Myths

 

Understanding Money Management in Forex Trading

Many beginners crash and burn because they don't implement money management with discipline. Some are even not aware of money management at all. Hence, we will learn the 5 main points in money management that should be understood and implemented properly with discipline before debunking the myths revolving around it.

 

1. The Risk Per Trade

The amount of risk per trade is measured in the amount of money, not pip. It is usually based on the percentage of our capital or account balance. Suppose we haven't entered a position and our account balance is still intact, then our risk per trade is the amount of loss that we set up when opening a trading position.

There is no absolute rule for this. What traders do might vary between each other, depending on their financial situation. What's clear is, we should only use spare funds that won't be used in the near future, and avoid trading forex by using the money for daily needs. Make an assumption that the fund allocated for trading forex is the fund you've prepared to lose, so you're not getting too emotional when trading.

See Also: The Secrets of Trading Psychology

To illustrate, professional traders rarely risk more than 3% of their total capital. On the other side, many seasoned traders recommend risking 3% to 5% of capital. Regardless of the risk that you set, however, you must feel comfortable with that choice, so that you can trade calmly and not too emotionally.

 

2. The Lot Size Per Trade (Position Sizing)

The lot size is also referred to as volume on the Metatrader platform. The method of setting volume trading based on the risk is commonly known as position sizing.

By using position sizing, the amount of risk would remain the same regardless of the stop loss level (risk in pip) that we set. For example, if we trade Standard Lot on the EUR/USD, the value per pip is $10. If our balance is $25,000 and we set the risk at 4%, then our risk is:

$25,000 X 4% = $ 1,000

Let's say we analyze that the most convenient Stop Loss is at 50 pips, thus our trading volume in Standard Lot is:

$1,000 / (50 X $10) = 2 lots

Well, if 2 traders have different amounts of capital but they set similar risk percentages as well as similar stop losses, obviously the lot size will not be similar. Traders with the bigger capital will have a bigger trading volume even though the stop losses (risk in pip) are the same.

 

3. Risk/Reward Ratio

The risk/reward ratio is a comparison between the risk (stop loss) and the profit target (reward). It is the next step in money management after setting the risk and the lot size.

Similar to how we can set the risk, there is no absolute rule to set a profit target. Nonetheless, we must be objective and realistic with the current market condition. Seasoned traders recommend a minimum risk/reward ratio of 1:2. This means that if our stop loss is at 50 pips, our profit target should be a minimum of 100 pips. The bigger the ratio, the better it affects trading profitability.

See Also: Understanding The Anatomy Of Forex Market

If we implement the risk/reward ratio consistently, we will gain considerable returns in the long term even though our overall win rate is considered small. For example, a trader has a win rate of 40%, which means that he only manages to earn profit from 4 out of the 10 positions that he has opened. However, after the profits and losses are calculated, the trader doesn't end up losing. He actually manages to gain a return of 10% because he implements a minimum risk/reward ratio of 1:2 on every position.

 

4. Mind Management

Besides money management, another important factor in trading is the involvement of emotion. Both affect each other and if not understood properly, it will bring negative effects in trading. Bad money management can destroy our trading, and so can uncontrollable emotion. For example, if we barely understand money management to the point we constantly lose, it will be hard for us not to involve emotion in trading.

Contrarily, the better we implement money management in trading, the more controllable our emotion is to respond to trading results. We can be considered to be successful in money management if we can effectively manage our fund in the trading account without involving emotion.

See Also: The Difference Between Failed And Successful Forex Trader

 

5. Mastery of Trading Strategies

If we don't fully master the strategy that we are applying on trades, it will only cause self-doubts when opening positions and the results will never be optimal no matter how good we are at understanding money management.

Trading strategy and money management are the main components of the trading plan which must be implemented simultaneously. Money management will work well if we master and trust the strategy that we are applying so that it will bring consistent profit for a long time.

 

The Myths in Money Management

Almost every trader understands that money management is a very important aspect to have profitable trades. Money management must be implemented in every open trading position in order to avoid loss while optimizing profit. Unfortunately, there are some myths in money management that are still believed by forex traders even though they are not entirely true.

 

Traders Must Always Focus on Pips

"What are the TP and SL?"

"The TP is 100 pips, the SL is 50 pips."

We often find traders who set the risk and the target profit in pip as exemplified above, instead of in a particular amount of money ($). The idea is based on the assumption that traders can avoid being too emotional by not involving real monetary units in profit and loss calculation.

The truth is, professional traders calculate their risk and profit targets directly in the amount of money. Why so? Because they know that the main goal of trading is to gain real profit, thus the risk and reward must be set in the value of money as well. Setting risk and profit targets this way will also bring forth a better psychological approach.

In addition, professional traders perceive forex trading as a business. Every trade is a transaction that puts real money at stake, thus the practice of setting the risk in pip is rather irrelevant. The risk in pip doesn't always correlate with the risk of big capital, because it will also be determined by lot size and leverage.

See Also: How Much Leverage from Broker You Should Use?

 

2% Risk Rule is Mandatory

As mentioned previously, one of the most popular money management strategies is by risking a certain percentage of the capital. The truth is, this is relative and depends on the balance of each trader. A good way of setting flexible and effective risk doesn't always have to be set in the percentage of capital. This can be seen in the example below:

A believes the myth of risking 2% of capital whereas B ignores it. Let's say A sets the risk at 2% of capital, while B sets the risk at a certain fixed amount of money. Their respective balance is $5,000 and the number of positions is 4 with risk/reward ratio of 1:3. Their win rate is 50%.

A's trading results:

Risk = 2% x $5000 = $100
Trade #1 (loss) = $5000 - $100 = $4900
Trade #2 (loss) = $4900 - $98 = $4802
Trade #3 (profit) = $4802 + $288 = $5090
Trade #4 (profit) = $5090 + $305 = $5395

B's trading results:

Fixed risk at $200
Trade #1 (loss) = $5000 - $200 = $4800
Trade #2 (loss) = $4800 - $200 = $4600
Trade #3 (profit) = $4600 + $600 = $5200
Trade #4 (profit) = $5200 + $600 = $5800

From the example above, we can see that B has better profitability than A. It proves that we don't have to always use the 2% risk rule when it comes to money management.

 

Big Stop Loss Entails Bigger Risk

Many traders think that if they set the stop loss too far from the entry position, their risks will multiply as well. Perhaps, this opinion is not exactly wrong. But if they understand the concept of setting position sizing, then this myth can be easily debunked.

As explained in the previous part, position sizing is the concept of adjusting the size of the trading lot with the desired stop loss level. For example, if the risk of a trade position is set at $200 and the stop loss is at 100 pips, the lot size would be set at 2 mini lots, which approximately hold a value of $2 per pip ($2 per pip x 100 pips = $200).

See Also: Turning Position Sizing into 5 Money Management Tricks

However, if we don't adjust the lot size and only focuses on the stop loss, the myth becomes true. Example: A and B trade on 5 mini lots ($5 per pip) no matter what happens. A set the stop loss at 50 pips while B at 200 pips. When the market condition is against their positions, both of their stop loss levels are hit, causing A to lose $5 x 50 pips = $250, while B loses 4$ x 200 pips = $1,000.

The bottom line is, the implementation of proper money management doesn't only depend on the stop loss level. Traders need to understand the concept of position sizing to be able to manage more reliable money management.

 

Risk/Reward Ratio is Not That Important

Many beginners disregard the risk/reward ratio. Instead, they only set the stop loss without determining the profit target. As a result, they are panicking when the price reverse against their trades.

As a matter of fact, professional traders always focus on the risk/reward ratio for every position with realistic profit targets. They have understood that forex trading is a game of probability and proficiency in capital management. The risk/reward ratio must be set thoroughly to generate an accountable profit/loss percentage in the entire trades.

 

Conclusion

From the discussion and examples above, we can conclude that proper money management is not always the same as what we commonly know. In fact, we should approach what others might say about money management critically. If we have found the right money management, profitable trades will come within our reach sooner or later.