In terms of achieving Forex trading success, your exit strategy is just a important as your entry signal to a trade. If you don't know the basics of money management when trading currencies and appreciate its importance, you will soon be one of the majority of traders who lose trading currencies.
Risk Management An Introduction
Money management is simply - managing the risk reward per trade and also refers to, managing the risk to reward of total account equity.
In this article, we are going to give you the basics of protecting your equity and give you simple money management techniques which will not only help you protect your account value, they will also help you maximize growth, on your trading capital at the same time.
Simple and Flexible Money Management Techniques
There is a lot of Forex education online which will give you mathematical equations and models, to help you manage risk which are rigid, risk management formulas but money management doesn't have to be complex. You can manage risk with rules which are simple and flexible. By flexible I mean, your strategy will still be rule based but the risk you take on individual trading signals should change, in relation to your trading accounts performance.
Lets take a look a how to implement, solid money management principles on your trading account.
Working out Where to Put Your Stop Loss Order
If you have a trading signal you want to put in the market, you will need to decide how much you risk to your stop loss. In my view, most novice traders put their stops to close to their entry price and think, their restricting risk but in reality – there doing the opposite and increasing it. They will put a stop behind a chart high, low or an important resistance level which is just a few ticks. When working out stops, you need to have an understanding of volatility and in addition, never put your stop where other traders cluster them.
Try and have your stop slightly back from theirs, these stop clusters get taken out the market and then, the price falls back the way these traders thought it would but the reality for them is they have a loss but could have had a profit if – they had taken a little more risk to the stop loss level. This extra risk is more than compensated by the extra amount of profit they can make by taking it.
Once you have worked out the number of pips you want to risk to your stop loss, , you then need to calculate how much you should risk in terms of lot size or exposure so how much of your account equity should you risk on the position? There are many views on this in the Forex community and the two most common are summarized below and also my own view on the best risk control strategy to use.
How Much Account Equity Should I Risk on a Trade?
Risk a Set Percentage Per Trade
The commonly accepted wisdom is to risk 2% per trade and this sounds like good advice as the risk is small but for most traders trading small accounts its not a great idea. Consider this, you have a $3,000 account and risk $60.00 per trade so not only are you not going to make much money on this percentage, if you hit a losing streak, the risk you take becomes smaller so it's an uphill task to get back.
The 2% level is used by many professional fund managers but there trading hundreds of thousands or millions and it can work for them because, they diversify across a huge amount of contracts and also have a low target growth with most funds aiming to make 10% + per annum.
Most traders who trade for themselves don't have the patience to wait for a draw down to recover and in my view can take more risk as 10% per annum is a very small target growth.
Risk a Fixed Monetary Amount
This simply changes it to a monetary amount so rather than risk a percentage you risk a set amount of dollars and this in my view is a better strategy. If you have $3,000, it might be $100.00 or $200.00 whatever amount you are comfortable with in relation to - the hit rate on your strategy. Not only does risking a bigger amount on a small deposit ( and by small, I mean under
$100, 000) make you more money, it will also allow you to recover from a draw down quicker. This trading method is a good one but the best way to manage risk and maximize returns is to vary the amount of risk you take per trade.
Flexible Amounts Per Trade
The real pro traders learn, to vary their bet size in relation to how well their doing and also in relation to how they view the odds of a trade. This is an art rather than a science but is based on the concept that - when your losing you reduce bet size but you will increase it if you are doing well and sometimes, when you see a set up, you have a strong conviction about you risk more.
In gaming theory variation of bet size, has been proved to be far more effective at making profits, than a set bet size.
Before everyone tells me, gaming theory has no place in Forex trading strategies – it does. The reason it is very applicable in terms of trading Forex is due to the fact were dealing in a market which is all about probabilities – NOT certainties. Just like in a game of poker or blackjack you have human opponents.
When trading against other humans, the best traders will bet big when, they see the right set up to take advantage of trader psychology. Just like a poker player, they will have calculated the odds of the hand they hold (their trading signal) and the prospect of their opponents losing money ( Looked at the psychology of their opponents) and on this basis, they will decide how much to risk.
Simple Risk Control But More than Just Maths
I find the endless mathematical models for risk control boring, most belong in text books and have no place in the world of trading. A perfect example is Modern Portfolio Theory. You have the theory that if you trade uncorrelated currency pairs, you have less chance of losing money and a better chance of maximizing profits – its not true in the real world. Any contract can go against you, your success is down to your trading edge. In addition, even if the theory worked in term of trading non correlated trades ( which it doesn't) you will end up with losers, eating into your winning trades!
The above is a well thought out theory which doesn't work in practice. When trading currency markets, you need to control risk but you also need to think about each trade in relation to the odds and how well your trading account is doing overall and this means - being flexible in my view. You don't need to use complex mathematics, you just need common sense and the discipline to execute your trading plan.
As you can see from the above, risk management is vital but it doesn't need to be complex and anyone can apply the money management tips above easily. To become a successful Forex trader you need a trading strategy with an edge which is simple, flexible risk control rules and if you then apply it with discipline you will make money.
The real key to making big profits on your account is to know, when to risk more on the really high odds set ups. This is down to you but if you do have the courage to do it on the really high odds trading you will enter the true elite of Forex traders.
If you want to make big gains trading currencies, just as in life at some point you have to bet big. If you have understood all the above, you can implement good risk control while at the same time, allowing you to build serious wealth in Forex trading.