We’ve all heard about money management, but what are the most important rules? This article will cover four of these in forex.
What do Thomas Tusser’s now-legendary poem quote ‘a fool and his money are soon parted’ relate to the realm of forex? Everything, certainly. All traders are in the business of making money, but handling it respectfully and consistently is another dilemma.
Getting to this destination involves a meticulous process of counting where money is allocated, why it’s allocated, and to what magnitude. We refer to this ideology as money management in forex, which is just as important as the analytical side of trading.
Not respecting money management is the main pitfall for many struggling and losing traders who may be outstanding technical analysts. Regardless of someone’s trading style and philosophies, some rules remain consistent across the board, which this article will briefly cover.
#1: Trading only with disposable risk capital
This concept serves as the foundation for everything else that’ll be discussed in this article. The idea of using disposable income for one’s trading account applies to everyone, particularly newer traders going live for the first time.
By disposable, analysts refer to funds separate from someone’s daily living expenses, savings, and taxes. A common error for newer traders is not adhering to this notion. They will often underestimate the risk of ruin or of losing.
Using non-disposable income increases the chances of someone having too much of an emotional attachment to their money. All successful traders maintain a neutral state of mind regardless of the outcome of their positions.
Although it’s impossible to remove emotions entirely, one of the fundamental methods for trading comfortably is only using disposable capital.
#2: Always use a stop loss for every position
Debates continue over the importance of using a stop loss. In truth, no other autonomous options exist for the average retail trader to handle their losses than using stops. Unless someone uses more of a buy and hold strategy, all retail traders essentially look to time the market through the most precise entries possible.
Stop losses are pretty much the only real way to manage losses. Arguments suggesting stop losses are detrimental don’t consider how most incorrectly use them. Essentially, having a stop in place for every trade is of huge significance.
We should also remember that stop losses don’t just apply to minimizing one’s downside; it’s also crucial for locking in profits. The challenge is knowing at which levels a trader should secure some gains in a profitable position. Several methods exist for achieving this.
The point is one should also know how and where to use stops when the market is moving in their favor. Many traders can quickly turn a profitable trade into a losing one by not securing their profit at logical levels.
#3: Keeping risk consistent through appropriate position sizing
Position sizing is another element some might not appreciate fully, leading to a few dangerous situations. One common error is using an arbitrary fixed position size regardless of the pair in question.
It often happens that traders cannot maintain a consistent amount of risk, dramatically affecting their equity in the long run. The second issue is focusing too much on the actual lot size instead of the real monetary risk.
Keeping risk consistent does not mean a trader will always risk the same amount of money. As someone’s account grows over time, this naturally allows for more margin to open bigger positions.
Even in this scenario, a knowledgeable trader will understand and plan how to keep the appropriate dollar amount for every position by adjusting the position size according to the stop loss distance.
For instance, let’s assume someone has decided to risk $100 per trade. If one position required a 50 pip stop and another needed a 75 pip stop, they would need to adjust their size in each scenario to ensure the risk is still at $100.
By consistently implementing this concept, one will not fall prey to using the same position size every time since every trade will have independent parameters.
#4: Use risk-to-reward ratios
Like stop losses, some may believe risk-to-reward is an irrelevant concept. Ultimately, trading is a game of probabilities with a lot of room for error and interpretation. However, the plus side is trading allows one a much larger reward that will cover their losing positions.
Numerous studies have been done proving that, even with a sample of random entries with a fixed stop loss and profit target, it’s possible to end up with a profitable account. Even when traders believe they have an edge in the markets, it becomes hard to make money without thoroughly implementing risk to reward.
Needless to say, this concept has some flaws, as with anything else. However, the point is every serious trader appreciates the key to long-term profitability is knowing their winners have to be marginally larger than their losses. The ratio, whether 1:1 or 1:5, is beneficial.
But what’s more important is how to assess the potential reward for each position and to look for methods of maximizing the return through techniques like trailing stops, scaling in, holding trades for long, etc.
Overall, the consistent application risk-to-reward coupled with an effective trading method gives a trader the best shot of ending up with profits in an environment that may seem like a random chance.
Albert Einstein once said, “Many of the things you can count, don’t count. Many of the things you can’t count, really count.” Is it safe to assume trading currencies is a numbers game?
Ultimately, it is. A trader’s success primarily boils down to how well they can count their money. We can summarise the simplicity of trading by finding ways of consistently having bigger wins and smaller losses. After we tally up both, the final numerical result should be positive.