Think of your trading capital like business capital. You need your business funds to pay expenses, buy inventory, pay salaries, and keep your business open even through the lean months. If you overspend in a month when the revenue generated is poor, you may not be able to pay everything you need to. You may end up taking out loans to cover the lean months or closing your doors forever.
With forex, you can only trade when you have the capital to do so. There are ways for you to extend your capital, but leverage can lead to margin calls, which leads to the use of more capital for a trade than you want to afford. Setting up proper money management for each trade is essential for your long-term forex success.
A Bit on Leverage
Leverage is essentially a loan that allows you to open a larger trading position than you could with the capital you have. If you trade $1,000 of your cash, you could for example open a position like you hold $100,000 (in case of 1:100 leverage). By using the leverage on a maximum level always expose you to potentially high profits, but proportionally increased risk too.
A margin call happens when the market has moved against your position and the amount of money in your trading account does not cover the amount leveraged. The broker would ask you to deposit more money or will close your lossy positions automatically to prevent further losses exceeding your capital.
It is not a good situation to be in and that´s the reason why every professional trader should use a proper forex money management system.
Of course, you should also have your own personal money management system (regarding your personal finances), and always use the funds you can spare for trading in forex. If you have $50,000 in a savings account that is for retirement or college tuition, you shouldn’t fully use it in a forex trading - just a small part that you can afford to loose (in the worst-case scenario).
However, a proper money management system will always minimize losses, maximize profits and prepare for any risks involved in forex trading. With the combo of high-quality trading system, enough knowledge and experience, proper money management and the right and fair broker, your path to a long-term profitable forex trading will be well-established.
What Money Management Does
Money management allows you to adapt to the current market. You have to assess how the current market is moving, the conditions, and volatility of the market to place a successful trade. With proper money management techniques, you can then calculate a proper value of your order volume, and always risk only as much as you can afford to loose. The trade may not give you millions in profit; however, you are earning money rather than losing it with reckless trades.
Proper money management also helps you to trade with a professional outlook versus on emotions. Emotions are damaging to profitable forex trades. One minute you can be highly successful, and the next take too risky trade that leaves you without capital to trade.
Risk Reward Ratio
Everyone assumes you should set a risk reward ratio at a certain proportion for every trade. Traders then adapt to setting a 1 to 2 (or even more) risk reward ratio for each trade they make (like when risking 100 USD, setting 300 USD Profit-Target). When using fixed risk reward ratio, usually their capital continues to disappear because the fixed ratio is not correct from a long-term perspective.
Risk reward ratios need to be set based on the current market volatility and structure. You need to be adaptable versus set in stone, when it comes to the risk reward ratio.
The best way to explain this is to look at two examples. Let’s say you set up a trade using 100K units buying or selling the EUR/USD. Each pip is worth $10, so when the market moves 100 pips there is a profit of $1000. It sounds great, but if you set your risk reward ratio at 2%, then you have to protect your position with a tight stop, for example 10 pips only. If the market moves up 10 pips, and then back 20 pips before it makes the 100-pip movement, your position would be closed. You would lose out on any profit you could have made.
However, if you pay attention to the market volatility, set a percent risk on an appropriately sized trade, then you can make a modest profit. For example, a smaller unit size would allow you to stay in the market for the 100-pip profit. Unfortunately, the pip would for example be only worth $1 when you trade 10K units, but you won’t lose as much of your capital.
The risk reward ratio you set must account for the current market structure, market volatility, and market movements before you choose the position size you will enter for a trade. Below is a quick checklist that you should always go through before opening a trade:
What Profit-Target can I place based on current market volatility
Entering the trade
The trading volume is the amount of currency being traded. In other words, with significant unit sizes, the profit or loss increases. By lowering the unit sizes, the profit or loss decreases. Proper order volume (correct positiong sizing) is one of the most important parts of forex money management as it allows you to control the risk and avoid unexpected losses. Always set your percentage risk, stop-loss that you need to enter when opening a trade and calculate correct position size based on that by using our useful calculators.
Volatility is a statistical measure. Volatility is considered “the amount of uncertainty or risk” regarding the change in price of a currency. A high volatility means the security’s value can be spread over a larger range of values, so the price can change drastically in a very short period. A lower volatility shows less price fluctuation.
Volatility and volume determine how the market moves. When there is high interest in a currency pair, the volatility and volume will be higher, which can lead to more significant movements.
However, you also must understand how the market is trending in those time frames. Is the currency pair sticking to a support and resistance pattern? Are traders getting in when the price is low and waiting for the rate to increase to a certain point? Is the currency pair breaking the resistance line it has been at due to a change in market conditions?
Listening to market movements and combining it with current trade patterns will help you determine the possibility of earning a profit and what type of profit that may be.
For example, if you see a support and resistance pattern that shows no signs of ending, you are in a position to calculate a risk reward ratio that allows for a higher profit, i.e. your position size can be increased (accordingly to your affordable % risk), with a stop loss set back farther from the current currency rate.
TIP: You can effectively expose current market structure and volatility by using our free forex indicators.
Setting the Percent Risk for your Risk Management Plan
What is your capital to trade? Everyone will have a different answer. You may have $100k and someone else may have $2 million to trade. Another person may have $1,000 to trade. And everyone can participate in a forex trading. Someone wants to trade aggressively and setting 5% risk per trade. While someone else would like to risk 0,5% per trade only. The risk that you will take on every trade should fit your style and your comfort zone.
Always use Stop-Losses
Stop losses help you limit your losses, keep to the percentage of risk you are willing to have on a trade, and increase the potential profit.
If you know there is some Price Action pattern, with nice 100 pips profit potential due to support and resistance level, then you would probably like to increase your lot or position sizing to gain a higher profit. However, keep in a mind that you still have to enter the position with a clear exit strategy, which means you will know when to sell if the market moves against your position.
Every money management strategy should have a clear plan for entry into the market and a clear exit (both in case of profit or loss).
Types of orders for closing forex trades
Three orders can be used, which include two kinds of stop losses.
A regular stop loss is set at a certain point from the entry. For example, if you enter at 1.3650 and you determine the risk percentage should be 2%, based on current volatility you may need 100 pips stop loss, then you can trade with for example a position size of 1,000 units. If the market moves against your position, your trade will close at 1.3550. This limits your loss to 100 pips or $10. The second option is a trailing stop loss. The trailing stop loss follows as the price moves. For example if the price moves to 1.3660, then your stop loss is set at 1.3560. Each time the price moves, the trailing stop loss stays 100 pips (depending on your setting) off the current currency rate. If the price reaches 1.3750, then drops back - you are guaranteed an exit at 1.3650. If the market drops to 1.3700 and then moves to 1.3770, your stop loss continues to move up. However, if the price drops to 1.3650 or below, you sell out at 1.3650.
To activate the trailing stop loss, simply right-click at your opened order and choose "Trailing stop". The MT4's trailing stop is set in points, so keep in a mind that 1 pip = 10 points (in case of USD and other pairs are quoted with 5 decimals and JPY pairs with 3 decimals).
You are wondering how you can get your profit, if you leave your trade open. Yes, for the profit to be made you need to close the trade. The stop loss is there to prevent a market movement against your position, trailing stop-loss can be a very effective technique if you catch significant market moves, but you maybe still want to take your profit when the market has topped out.
In that case you can use a regular take-profit. You can for example close the position when you have earned the 100 pips profit you were aiming at. You will enter an order to close out the position at a certain level in a profit. If the order is filled, the trade is closed automatically.
It is important to note that Stop-Loss and Take-Profit orders are placed and stored at the server´s of your broker, and these orders will get executed automatically even if your computer will be turned off. But the trailing stop feature is built in the MT4 trading platform and to make the trailing stop work correctly, your MT4 trading platform has to be online and running.
Taking a Partial Profit
Another possible technique that you can include in your trading strategy. This allows you to take a partial profit and keep your current position making further profits. Let’s say you were trading on the support and resistance. The market took a sudden move, a breakout move, where the currency price went above the 100-pip movement you expected. Now, you want to keep the position open, but not risk the profit you already made.
You can partially close your trade by closing for example half of your position size. Also do not forget to move Stop-Loss of the rest of the position to the Break/Even level (price level where you have opened the trade). Using this technique helps you stay and earn more profit, without fear that the market will move against you and you will lose all the profit you made.
To close your order partially, double left-click at your opened order and choose the volume that you would like to close and click the yellow close button.
Money management is about protecting your open position and limiting your risk. Each trade will be different because the market volume and volatility will determine the market changes. You can always protect your capital at a % risk; however, will that percentage keep you from gaining a decent profit? It is actually about the position sizing you choose based on the percentage of risk you can afford to loose and current market structure and volatility.
High Risk Warning: Please note that foreign exchange and other leveraged trading involves significant risk of loss. It is not suitable for all investors and you should make sure you understand the risks involved, seeking independent advice if necessary.
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