No matter what kind of Money Management you have, allocating your capital and risk in order to attain profits is very crucial for your success as a trader in the forex market.
Money management in forex trading refers to the ways you allocate your capital and risk to attain profits. There are various ideas on money management among traders. Money management has a lot of benefits for traders, including reducing stress, preventing risk, and giving them financial security. No matter what kind of Money Management you have, it is crucial for your success as a trader in the forex market. Without having proper money management, you could lose out all of your capital in a short time. Therefore, having a reliable system in place is a must.
Why is Money Management Important?
The real question is, must trader uses money management? What kind of benefits can they get from implementing good money management?
1. Financial Security
The idea of money management is to make sure traders have better financial security during their trading endeavors. Implementing good money management principles in forex trading ensures that traders' actions are always in line to preserve their capital. By doing so, they can remain liquid and take positions on potentially profitable trades in the present and future.
2. Prevent Losses
Adopting the right attitude towards money management involves making decisions professionally and rationally without allowing emotions or sentiments to cloud the trader's judgment. Effective money management strategies align their risk tolerance with the potential market rewards at any time. By doing so, traders will be better equipped to determine the optimal time to implement stop-loss orders, close out a position, or take profits.
3. Reduces Stress
Implementing a suitable money management strategy can significantly reduce stress levels for forex traders. Incurring large losses can cause mental stress and pressure traders to seek out new trades, potentially leading to unwise financial decisions. Managing this pressure is essential to making informed and professional financial decisions, as it directly affects a trader's ability to conduct a proper analysis. By reducing stress through effective money management, traders are better positioned to make good financial decisions, which can positively impact their overall well-being.
What Will Happen if You Ignore Money Management?
Ignoring money management in trading can lead to disastrous consequences for traders. Trading in financial markets comes with inherent risks, and losing money is easy whenever you enter a trade. Money management is a crucial element that helps traders limit their market exposure and manage risk. It ensures traders can withstand losses within their trading system without "running down" their accounts.
However, if traders ignore money management, they risk making emotional trading decisions and overexposing their accounts to the market. This can lead to a rapid depletion of their investment capital and ultimately wipe out their account. Even if traders have a profitable trading system, ignoring money management can quickly lead to failure. Therefore, traders need to understand and implement proper money management techniques to avoid the consequences of ignoring them.
Money Management Methods
Several money management methods are available all around. Here are some of them.
1. Position Sizing
Investors must determine their account risk to use appropriate position sizing for a trade, usually expressed as a percentage of their capital. Retail investors generally risk no more than 2% of their investment capital per trade, while fund managers tend to risk even less. For instance, if an investor with a $25,000 account sets a maximum account risk of 2%, they cannot risk more than $500 per trade (2% x $25,000). Even if they lose ten trades in a row, they will only lose 20% of their investment capital. This method allows traders to decide how much money they can invest in a trade. That means it will be easier to manage their funds.
2. Risk/Reward Ratio
One of the most popular ways of forex money management is through risk/reward ratio. This method requires the trader to divide the difference between the entry and stop loss prices by the profit target and the entry point price level (reward). While it seems complicated, calculating the risk/reward ratio is pretty simple. Traders can use this formula to calculate their ratios.
Risk-reward ratio formula:
Risk/reward ratio = absolute value (price entry value – stop loss value) / absolute value (price entry value – target price value)
For example, based on this risk-reward formula, if we buy GBP/USD and the entry price is 1.3, and stop loss is 1.2, and the target is 1.5, then:
(Entry price – stop-loss) = 100 pips (because from 1.3 - 1.2 there are 100 pips.)
(Entry price – target price) = 200 pips (because from 1.3 - 1.5, there are 200 pips.)
Some broker over risk reward calculator. Traders can make use of this to calculate their risk rewards ratio easily. By understanding their risk rewards, traders can easily manage how much money they can sacrifice in each trade.
3. Determine the Maximum Drawdown
Setting an appropriate max drawdown can be a good money management method. The drawdown is the disparity between the highest value of the account over a specific period and its current value after the losing trades. For instance, if a trader initially has GBP10,000 in their account and loses GBP500, this would result in a 5% drawdown (since 500 is 5% of 10,000). A more significant drawdown makes restoring the account balance with profitable trades more challenging.
It's better if you establish a maximum acceptable drawdown level when backtesting a strategy. For instance, if you test your strategy over 60 trades and the drawdown never surpasses 6%, you may set the maximum drawdown at 6 or 7%. If the account decline reaches that level, you will adhere to your money management guidelines and close some or all trades to restore the account balance.
4. Use Leverage
Another money management technique that you could use is setting the leverage. Forex traders can use leverage to open positions larger than their capital would permit. This involves borrowing money from a broker to create a leveraged position. The amount of leverage you use can highly affect how much money you should use for trading. Because it gives an extra boost, you do not have to use too much money to open more prominent positions. For instance, with a leverage of 1:20, you could invest £500 and open a position worth £10,000. By giving access to a larger position with a smaller amount of money, it has the potential to amplify profits from successful trades.
The Keys to Successful Money Management
In addition to implementing the money management methods mentioned above, you should also adhere to the following tips to optimize your trading performance:
- Trade What You Can Afford to Lose
This statement emphasizes the importance of money management in trading. This means that you should only risk an amount of money you can afford to lose without adversely affecting your financial situation or lifestyle. By doing so, you can avoid making emotionally charged decisions and are less likely to experience undue stress and anxiety associated with trading losses.
- Don't Chase the Market
Sometimes, you may feel the urge to chase the market and enter trades impulsively, especially after experiencing a loss. However, it is essential to remember that the market is not obligated to provide profitable opportunities and is neither moral nor immoral. It is simply a mechanism of supply and demand, responding to various economic and political factors. So, stick to the money management plan made beforehand and eliminate the risk of losing too much money.
- Don't Deviate From the Trading Plan
Sticking to a trading plan requires discipline, patience, and a long-term perspective. You should avoid making emotional decisions based on short-term market movements and focus on the overall strategy outlined in your plan. Traders who follow their trading plan are more likely to achieve consistency and profitability. There's no use in using a risk/reward ratio if you don't apply the rule with discipline.