Top 10 Forex money management tips
Tip #1: quantify your risk capital
Many of the important aspects of money management proceed from this key value.
For example, the size of your overall risk capital will be a factor determining the upper limit of your position size.
You might consider it prudent to risk no more than 2% of your overall risk capital in any one trade.
Tip #2: avoid trading too aggressively
Trading too aggressively is perhaps the biggest mistake new traders make.
If a small sequence of losses would be enough to eradicate most of your risk capital, it suggests each trade has too much risk.
A way to aim for the correct level of risk is to adjust your position size to reflect the volatility of the pair you are trading.
But remember that a more volatile currency demands a smaller position than a less volatile pair.
Autochartist is provided free to Admiral Markets clients and includes PowerStats.
The PowerStats tool shows average pip movements in specific time frames, as well as other measures of expected volatility.
Tip #3: be realistic
One of the reasons that new traders are overly aggressive, is because their expectations are not realistic.
They think that aggressive trading will help them get rich quickly.
However, the best traders make steady returns.
These profits can become very large over the years, through the power of compounding.
But you cannot get compounded returns if you quickly blow up.
Realistic goals and a conservative approach is the right way to start trading.
Tip #4: admit when you are wrong
The golden rule of trading is to run your profits and cut your losses.
It’s essential to exit quickly when there’s clear evidence that you have made a bad trade.
It’s a natural human tendency to try and turn a bad situation around, but it’s a mistake in FX trading.
Here’s why.
You cannot control the market.
Recognising a losing situation and having the humility to admit you are wrong, will curtail losses before they can grow to a damaging size.
It is wiser to end a loss, than to gamble with it.
Tip #5: prepare for the worst
We cannot know the future of a market, but we have plenty of evidence of the past.
What has happened before may not be repeated, but it does show what is possible.
It’s therefore important to look at the history of the currency pair you are trading.
Try to get a feel for the magnitude of extreme price moves, so you can consider the worst case scenario for a trade.
Looking into the abyss like this is not comfortable.
But it is useful.
Think about what action you would need to take to protect yourself in such a scenario.
Do not underestimate the chances of price shocks occurring.
To be taken out by an adverse price movement is not unlucky – it’s a natural part of trading.
So, you should have a plan for such a contingency.
You don’t have to delve far into the past to find examples of price shocks.
In January 2015, the Swiss franc surged roughly 30% against the euro in a matter of minutes.
Tip #6: envisage exit points before entering a position
Think about what levels you are aiming for on the upside and what loss is sensible to withstand on the downside.
Doing so will help you to maintain your discipline in the heat of the trade.
It will also encourage you to think in terms of risk versus reward.
Tip #7: use some form of stop
Stops help to cut losses and are especially useful for when you are not able to monitor the market.
At the very least you should use a mental stop if you don’t want to use an actual order in the market.
Price alerts are also useful.
Tip #8: don’t trade on tilt
At some point you may suffer a bad loss or burn through a substantial portion of your risk capital.
There is a temptation after a big loss to try and win it all back with the next trade.
But there’s a problem.
Increasing your risk when your risk capital has been stressed, is the worst time to do it.
Instead consider:
…reducing your trading size in a losing streak…
…or taking a break until you can identify a high-probability trade.
Always stay on an even keel – both emotionally and in terms of your position sizes.
Tip #9: respect and understand leverage
One of the advantages of Forex trading, is powerful leverage ratios.
Leverage allows you to command an FX position that is much larger than the capital you deposit.
This offers the opportunity to magnify profits made from the risk capital you have available.
But it also increases the potential for risk.
In other words – it allows you to ramp up the risk to get greater profits.
This is a useful tool, but it is very important to understand the size of your overall exposure.
Tip #10: think long term
It stands to reason that the success or failure of a trading system, will be determined by its performance in the long term.
So be wary of apportioning too much importance to the success or failure of your current trade.
Do not bend or ignore the rules of your system to make your current trade work.
Money management tips for Forex trading
Trading is not just about a successful trading strategy.
It’s also about staying in the game long enough to allow the strategy to succeed.
Like all aspects of trading, what works best will vary according to the preference of the individual.
Some traders are willing to tolerate more risk than others.
But if you are a beginner trader then no matter who you are:
…a robust tip is to start conservatively.
Money Management Matters
Put two rookie traders in front of the screen, provide them with your best high-probability set-up, and for good measure, have each one take the opposite side of the trade. More than likely, both will wind up losing money. However, if you take two pros and have them trade in the opposite direction of each other, quite frequently both traders will wind up making money – despite the seeming contradiction of the premise. What’s the difference? What is the most important factor separating the seasoned traders from the amateurs? The answer is money management.
Like dieting and working out, money management is something that most traders pay lip service to, but few practice in real life. The reason is simple: just like eating healthy and staying fit, money management can seem like a burdensome, unpleasant activity. It forces traders to constantly monitor their positions and to take necessary losses, and few people like to do that. However, as Figure 1 proves, loss-taking is crucial to long-term trading success.
Amount of Equity Lost Amount of Return Necessary to Restore to Original Equity Value
25% 33%
50% 100%
75% 400%
90% 1,000%
Figure 1 – This table shows just how difficult it is to recover from a debilitating loss.
Note that a trader would have to earn 100% on his or her capital – a feat accomplished by less than 1% of traders worldwide – just to break even on an account with a 50% loss. At 75% drawdown, the trader must quadruple his or her account just to bring it back to its original equity – truly a Herculean task!
The Big One
Although most traders are familiar with the figures above, they are inevitably ignored. Trading books are littered with stories of traders losing one, two, even five years’ worth of profits in a single trade gone terribly wrong. Typically, the runaway loss is a result of sloppy money management, with no hard stops and lots of average downs into the longs and average ups into the shorts. Above all, the runaway loss is due simply to a loss of discipline.
Most traders begin their trading career, whether consciously or subconsciously, visualizing “The Big One” – the one trade that will make them millions and allow them to retire young and live carefree for the rest of their lives. In forex, this fantasy is further reinforced by the folklore of the markets. Who can forget the time that George Soros “broke the Bank of England” by shorting the pound and walked away with a cool $1-billion profit in a single day? But the cold hard truth for most retail traders is that, instead of experiencing the “Big Win”, most traders fall victim to just one “Big Loss” that can knock them out of the game forever.
Learning Tough Lessons
Traders can avoid this fate by controlling their risks through stop losses. In Jack Schwager’s famous book “Market Wizards” (1989), day trader and trend follower Larry Hite offers this practical advice: “Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade.” This is a very good approach. A trader can be wrong 20 times in a row and still have 80% of his or her equity left.
The reality is that very few traders have the discipline to practice this method consistently. Not unlike a child who learns not to touch a hot stove only after being burned once or twice, most traders can only absorb the lessons of risk discipline through the harsh experience of monetary loss. This is the most important reason why traders should use only their speculative capital when first entering the forex market. When novices ask how much money they should begin trading with, one seasoned trader says: “Choose a number that will not materially impact your life if you were to lose it completely. Now subdivide that number by five because your first few attempts at trading will most likely end up in blow out.” This too is very sage advice, and it is well worth following for anyone considering trading forex.
Money Management Styles
Generally speaking, there are two ways to practice successful money management. A trader can take many frequent small stops and try to harvest profits from the few large winning trades, or a trader can choose to go for many small squirrel-like gains and take infrequent but large stops in the hope the many small profits will outweigh the few large losses. The first method generates many minor instances of psychological pain, but it produces a few major moments of ecstasy. On the other hand, the second strategy offers many minor instances of joy, but at the expense of experiencing a few very nasty psychological hits. With this wide-stop approach, it is not unusual to lose a week or even a month’s worth of profits in one or two trades. (For further reading, see Introduction To Types Of Trading: Swing Trades.)
To a large extent, the method you choose depends on your personality; it is part of the process of discovery for each trader. One of the great benefits of the forex market is that it can accommodate both styles equally, without any additional cost to the retail trader. Since forex is a spread-based market, the cost of each transaction is the same, regardless of the size of any given trader’s position.
For example, in EUR/USD, most traders would encounter a 3 pip spread equal to the cost of 3/100th of 1% of the underlying position. This cost will be uniform, in percentage terms, whether the trader wants to deal in 100-unit lots or one million-unit lots of the currency. For example, if the trader wanted to use 10,000-unit lots, the spread would amount to $3, but for the same trade using only 100-unit lots, the spread would be a mere $0.03. Contrast that with the stock market where, for example, a commission on 100 shares or 1,000 shares of a $20 stock may be fixed at $40, making the effective cost of transaction 2% in the case of 100 shares, but only 0.2% in the case of 1,000 shares. This type of variability makes it very hard for smaller traders in the equity market to scale into positions, as commissions heavily skew costs against them. However, forex traders have the benefit of uniform pricing and can practice any style of money management they choose without concern about variable transaction costs.
Four Types of Stops
Once you are ready to trade with a serious approach to money management and the proper amount of capital is allocated to your account, there are four types of stops you may consider.
- Equity Stop – This is the simplest of all stops. The trader risks only a predetermined amount of his or her account on a single trade. A common metric is to risk 2% of the account on any given trade. On a hypothetical $10,000 trading account, a trader could risk $200, or about 200 points, on one mini lot (10,000 units) of EUR/USD, or only 20 points on a standard 100,000-unit lot. Aggressive traders may consider using 5% equity stops, but note that this amount is generally considered to be the upper limit of prudent money management because 10 consecutive wrong trades would draw down the account by 50%.
One strong criticism of the equity stop is that it places an arbitrary exit point on a trader’s position. The trade is liquidated not as a result of a logical response to the price action of the marketplace, but rather to satisfy the trader’s internal risk controls.
- Chart Stop – Technical analysis can generate thousands of possible stops, driven by the price action of the charts or by various technical indicator signals. Technically oriented traders like to combine these exit points with standard equity stop rules to formulate charts stops. A classic example of a chart stop is the swing high/low point. In Figure 2 a trader with our hypothetical $10,000 account using the chart stop could sell one mini lot risking 150 points, or about 1.5% of the account.
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Figure 2
3. Volatility Stop – A more sophisticated version of the chart stop uses volatility instead of price action to set risk parameters. The idea is that in a high volatility environment, when prices traverse wide ranges, the trader needs to adapt to the present conditions and allow the position more room for risk to avoid being stopped out by intra-market noise. The opposite holds true for a low volatility environment, in which risk parameters would need to be compressed.
One easy way to measure volatility is through the use of Bollinger Bands®, which employ standard deviation to measure variance in price. Figures 3 and 4 show a high volatility and a low volatility stop with Bollinger Bands®. In Figure 3 the volatility stop also allows the trader to use a scale-in approach to achieve a better “blended” price and a faster break even point. Note that the total risk exposure of the position should not exceed 2% of the account; therefore, it is critical that the trader use smaller lots to properly size his or her cumulative risk in the trade.
FX_ArtOMoneyMgmt_2r.jpg
Figure 3
FX_ArtOMoneyMgmt_3r.jpg
Figure 4
4. Margin Stop – This is perhaps the most unorthodox of all money management strategies, but it can be an effective method in forex, if used judiciously. Unlike exchange-based markets, forex markets operate 24 hours a day. Therefore, forex dealers can liquidate their customer positions almost as soon as they trigger a margin call. For this reason, forex customers are rarely in danger of generating a negative balance in their account, since computers automatically close out all positions.
This money management strategy requires the trader to subdivide his or her capital into 10 equal parts. In our original $10,000 example, the trader would open the account with an forex dealer but only wire $1,000 instead of $10,000, leaving the other $9,000 in his or her bank account. Most forex dealers offer 100:1 leverage, so a $1,000 deposit would allow the trader to control one standard 100,000-unit lot. However, even a 1 point move against the trader would trigger a margin call (since $1,000 is the minimum that the dealer requires). So, depending on the trader’s risk tolerance, he or she may choose to trade a 50,000-unit lot position, which allows him or her room for almost 100 points (on a 50,000 lot the dealer requires $500 margin, so $1,000 – 100-point loss* 50,000 lot = $500). Regardless of how much leverage the trader assumed, this controlled parsing of his or her speculative capital would prevent the trader from blowing up his or her account in just one trade and would allow him or her to take many swings at a potentially profitable set-up without the worry or care of setting manual stops. For those traders who like to practice the “have a bunch, bet a bunch” style, this approach may be quite interesting.
Conclusion
As you can see, money management in forex is as flexible and as varied as the market itself. The only universal rule is that all traders in this market must practice some form of it in order to succeed.
Read more: Forex: Money Management Matters | Investopedia http://www.investopedia.com/articles/forex/06/fxmoneymgmt.asp#ixzz4FrymCeeY
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