This post deals with the myths and truths related to managing forex trading capital. Most of the information available out there is not of much help to professional traders. This is because the needs of each trader are different. The account size, risk profile, net worth, and skill levels vary from trader to another. Therefore, following a traditional money management principle will not be the right approach that all traders can adopt.
This is to say that using a small percentage of money in your account on a trade is purely an arbitrary approach to money management in forex trading. Read on to know more as to how professional forex traders manage money.
Money Management Myths
- Traders must focus on pips
When you started trading forex, you would have been told that you should focus on pips lost or gained instead of on gaining or losing dollars. The rationale behind this suggestion is to eliminate the emotional aspect by making you think of trading as a point game. You are doing forex trading to make money and, therefore, you should think in terms of money in order to keep the reality of the situation in focus. Business owners do not treat their profit and loss reports as a point game and detach themselves from the reality as to whether they are making or losing money. This is to say that you should treat trading as a business to consistently make profits. Risk and reward are part of any business transaction. So is the case with each trade executed by you. Trading becomes less realistic if you think only in terms of pips. This may ultimately lead you to treat trading less seriously.
- You can grow your account by risking 1 or 2 percent on every trade
This is a more common myth that you would have come across. Theoretically, it sounds good. However, the reality is that most retail traders start forex trading with less than $5,000 in their account. Therefore, it is not possible for them to grow their account effectively by risking just 1 or 2 percent per trade. In the percentage risk model, the position size automatically reduces as you lose trades. This is to say that you may start off well when using this model, but losing a string of trades can wipe out the gains. Then it will take a long time for you to get back the money you lost. This money management option might limit emotional trading mistakes in the beginning, but it will lead to over-trading eventually and badly impact your bottom line.
- Risk associated with wider stops is more than smaller stops
You may think that a wider stop loss increases your risk and a narrower stop loss decreases the risk on a trade. This is because you have not understood the forex position sizing concept clearly. Position sizing refers to the adjustment of the trading lot size to help you meet the desired stop loss setting and risk size.
Money Management Truth
Risk to Reward Ratio
Based FX Daily Report, Professional traders often focus more on the risk to reward ratio instead of analysing the markets or setting unrealistically wide profit goals. This is because they understand that trading works on probability principle and it involves capital management. It all starts with the use of a proven trading method that is slightly better than the random way of determining the market direction. A strategy devised on the basis of a price action analysis gives you an edge in the market.
In short, if you are trading currencies with less than $25,000 in your account, you must take profits at pre-decided intervals in order to maintain your sanity and grow your trading account. Entering into forex trades with open profit goals is not effective strategy, at least, in the case of small traders. This is because they never think of taking profits till the market swings back against them in a dramatic fashion.
If you have a strike rate of 40 to 50 percent, then you can make money on a consistent manner by implementing the risk to reward principle. You must learn to make use of well-defined price-action setups in order to enter the trades.
The power of these money management techniques lies in their ability to efficiently and consistently grow your forex trading account. However, the main underlying assumption when making these recommendations to you is that you are trading with the money you can lose. This means that there will not be any direct impact on your life if you happen to lose all of the money you have invested in currency trading. The idea behind the risk to reward strategy revolves around you having a competitive edge in the market, your knowledge that the edge is there, and how you make use of it.
While it is not recommend that you follow a pre-set risk percentage for each trade, it is important that you risk an amount that is acceptable to you. If the amount you risk is keeping you awake at night, then it is probably a little too much. For example, if your trading account has $10,000 in it, then you may risk a set amount of $200 to $300 per trade. Professional traders know how to judge the situation on the basis of the quality of the setup. This comes with experience. This means that you should hone your skills through a demo account prior to trading with real money. The forex money management strategy that has been discussed in this post provides you with a realistic way of effectively growing your account without the need to evoke over-trading which traders who follow the percentage risk option often resort to.
All said and done, money management has a key role to play in forex trading. Most people do not spend enough time in developing and implementing a plan. You will never make profits consistently until you improve your ability to manage money and consistently employ the same on each and every trade you execute.