Good money management skills are the
single most important difference between amateur and
professional traders. You heard me. If you have ever
dreamed of becoming a
successful forex
trader, you must learn money management.
Money management has nothing to do with how you budget
your spending or how much you put into your Forex
account. Whether you put in $1000 or $10,000 into your
account is not what we are talking about here.
Money management is all about
managing risk. All of us that trade currency have some
tolerance to risk. But there’s a difference between
having the ability to take risks, and engaging in risky
behavior.
There was a recent story where a
trader that worked for one of the big banks made some
bad trades and ended up losing the bank in excess of a
billion dollars. What happened? He was simply not
following basic money management rules that would have
saved his bank a lot of money, and probably his careers
as well.
You do not want to end up like this
guy for two reasons. First of all, you will be trading
with your own money, so losing your life savings is
simply not an option. I am assuming you started trading
forex to increase your income, not put your life savings
at risk. Secondly, you are smarter than that. If you
are reading this, it means you are smart enough to know
that education is the most power weapon in this game.
Learning just a simple strategy for managing your
bankroll will reduce the amount of headache and
heartache significantly. The following technique
is a simple, yet powerful rule that many experienced
traders still take to heart:
Never risk more than 2% of your
account balance
This is one of the most simple
money management techniques out there, and it works. It
simply states that for every trade you make, you should
not risk more than 2% of your balance. Say you just
opened up an account today and deposited $5000 in it.
You know that 2% of $5000 is $100, but what does this
mean for your trade? It simply means that you will put
in a stop loss such that it will close the position
automatically if you lose $100 on that trade.
However, for certain
online forex brokers,
you will need to specify the price of the stop loss as
opposed to the dollar amount. Let’s assume you are
trading a mini lot (10K units), which means each
pip is worth
approximately $1. Remember that 1 pip is 0.0001
dollars.
In our scenario, you can only risk
2% or $100 of your $5000 account balance. Say you
bought 1 mini lot (10K units) of EUR/USD at 1.41678,
then the stop loss should be set at 100 pips below that
amount, which is 1.41678 – (0.0001 * 100) = 1.40678.
This means that if the trade starts going drastically
against you, you will be stopped out at 1.40678, with a
maximum loss of $100.
Why is it important never to risk
more than 2% of your account balance? Well, the biggest
advantage is that it takes the emotion out of trading,
which is a very good thing. Emotions and trading do not
mix well. Losing is never a good feeling, but losing 2%
is a lot easier to swallow than losing 50% of your
bankroll.
When you lose 50% of your account
balance in one trade, funny things start to happen. You
will feel the need to gain it all back in one trade, so
you risk even more to break even. This usually leads to
disaster and you will see your account balance dwindle
down to zero in no time.
Now what happens when you lose 2%
of your account balance? Well, it’s only 2%, so you
move on the next trade without much though. You can
have 10 trades go against you in a row, and still be
down only 20%. The beauty of this rule is that it will
keep you in the game a lot longer.
When to Apply the Golden Rule
In a word, always. When you
are first starting out, apply the 2% rule on each and
every trade with no exception. Do not lose focus and do
not adjust your stop loss when the trade is not going
your way. Once you are more experienced, you may try
out other advanced money management techniques that also
work quite well.
Discipline is one of the keys to
becoming a
successful forex trader. If you know you are
not disciplined, and know you will not become a
disciplined trader, I would recommend withdrawing all of
your money right now and put the money elsewhere
because forex is not for you. Being disciplined is not
easy, and that is precisely why so few people ever
profit from trading forex.
It takes hard work to be
disciplined. Place a reminder in front of your computer
and make it a habit to always use a stop loss and
never risk more than 2% on a single trade.
Summary
Money management may be a foreign
topic for most people, but it shouldn’t be. It should
be on the forefront of every single trade that you
make. It should not be an afterthought, and definitely
should not be forgotten. Let me re-iterate the
importance of applying the 2% rule on each and every
trade. By following a simple money management
technique like the 2% rule, you will increase your
chance of success significantly.
Related Links
Forex Basics - The ABCs of Forex Trading
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