Forex Money Management
Money management is a way traders control their money flow: in or out of pockets... Yes, it's simply the knowledge and skills on managing a personal Forex account.
There are several rules of good money management:
1. Risk only small percentage of total account
Why is it so important?
The main idea of the whole trading process is to survive!
Survival first, and only then making money on top.
One should clearly understand, that Big traders first of all are skillful survivors. In addition, they usually have deep pockets, which means that under unfavorable conditions they are financially able to sustain big losses and continue trading. For the ordinary traders, the majority of us, the skills of surviving become a vital "must know" platform to keep trading accounts alive and, of course, to make good stable profits.
Let's take a look at the example that shows a difference between risking a small percentage of capital and risking a bigger one. In the worst case scenario of ten losing trades in a row the balance of trader's account will suffer this much:
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Apparently, there is a big difference between risking 2% and 10% of the total account per trade. A trader who has made 10 trades risking only 2% of balance per trade, under the worst conditions would lose only 17% of the total account. The same trader who had been exposing 10% of balance per trade would end up with loss of over 60% of the total account balance. A simple money management rule — significant results.
2. Rebuilding of a shrinking account is harder that it may seem to be
Let's take a look at calculations where a trader has lost some part of his account. How much effort will it take to recover the original account balance?| Account | % of account lost | New balance | Need to make |
| $ 5000 | 25% | $ 3750 | 35% of the new balance ($ 1250) to cover losses |
| $ 5000 | 50% | $ 2500 | 100% of the new balance ($ 2500) to cover losses |
| $ 5000 | 75% | $ 1250 | 300% of the new balance ($ 3750) to cover losses |
| Note that it's only to cover losses: Who is going to make money then..? And when? | |||
Now, there is a challenge: try on your demo account to rise up 300% or at least 100% of your original account trading as it would be real money. Will that be easy? I don't think so. Can you prove me wrong?
3. Calculate risk / reward ratio before entering a trade
When chances to win in a trade are smaller than potential losses, don't trade! Remember — staying aside is a position.For example: 40 pips to lose versus 30 pips to win, 20 pips to lose versus 20 pips to win — all that is a clear sign of bad risk management.
Before entering each trade, reassure that risk / reward ratio is at least 1:3, which means that chances to lose are tree times less than promises to win. For example: 30 pips of possible loss versus 100 pips of potential win is a good trade to consider entering.
Adopting this money management rule as a must, in the long run will dramatically increase trader's chances to succeed in making stable gains.
Next chart shows the "risk / reward" rule in practice.
Ten trades based on 1:3 risk / reward ratio were conducted. A trader was losing only $ 100 in each trade when he was wrong, but won $ 300 in each profitable trade.
| Trades | Losing trades | Winning trades |
| 1 | +300 | |
| 2 | -100 | |
| 3 | -100 | |
| 4 | +300 | |
| 5 | +300 | |
| 6 | -100 | |
| 7 | +300 | |
| 8 | +300 | |
| 9 | -100 | |
| 10 | -100 | |
| Total | - $500 | + $1500 |
| Grand Total | + $1000 in profit | |
As we can see, constantly using 1:3 risk / reward ratio and being successful only 50% of the time, trader will still make a profit. The higher the reward ratio (compared to risk ratio) the better are chances to end up in profit.
4. Learn to use protective stops
About protective stops and their importance for good money managementEvery day hundreds of traders blame themselves for being so naive and trading without protective stops. Hundreds of others lose funds worth weeks, months, years of trading just only in one very unsuccessful trade.And yet another hundreds of traders, having heard dozens of times about importance of protective stops, open new trades ignoring recommended money management rules.
Stop loss is not a favorite tool for many traders as it requires taking necessary losses, calculate risks and foresee price turns. However, such money management tool in hands of a knowledgeable trader becomes rather a powerful trading weapon than a tool of disappointment and painful losses.Every trader is free to develop or choose his / her own trading style and implement money management rules. We will go over several methods of using a stop loss tool.
a. Chart based Stop
Adopted by many traders, this stop relies on different chart patterns, indicators and signals received when using technical analysis of price moves at any given time. There are many styles, rules, techniques on how to and when to use a stop loss, associated with different technical indicators and different trading systems. Examples of some of them can be found at TrendLine Book and Fibonacci Book.There are many approaches to placing protective stops: stops based on swings high / low, stops using trend lines, fibonacci related stops, etc.
b. Margin Stop
It represents one quite interesting approach that would rather suite traders, who like placing all money at once on a particular trade. But at first, the trader should divide his account into several equal pieces to ensure that the whole capital will not be blown off in one shot. Supposing that a trader plans to spend 15 000 USD, it is suggested that the account opened with a broker "weights" between 1000 to 2000 USD.Then a "play" with a margin starts. Depending on the leverage that is going to be used and carefully choosing a lot size, a trader can calculate the point where a margin call will occur.
This point will work as a global stop loss, which if crossed will cause the account to be closed automatically.
A predetermined risk, no concerns about the manual stop loss, a maximum trading position size — all that creates the whole new approach to trading on Forex market.
c. Volatility related Stop
Price volatility can also be used to set a stop loss. During active hours with a high volatility market, a stop loss must be set further than usually to eliminate seldom noise of the price moves and react only on major changes. During low volatility market, a protective stop should be placed closer to be able to react in time when the price starts showing serious changes.One of the good technical tools to measure price volatility is Bollinger band.
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