Effective Forex money management can often mean the difference between a winning track record and losing one. It is by far one of the more important aspects of successfully trading the Forex market, yet it often effective forex money managementdoesn’t receive the respect it deserves.
Why is this?
Is it because there hasn’t been much material written about the subject? I don’t think so. One look online or even in your favorite trading book and you’re likely to see a plethora of information on the subject.
My personal view of why it doesn’t receive the respect it deserves is because it isn’t considered the “exciting” part of trading Forex. Let’s face it, we all want to talk about profitable trading strategies and the best markets to trade, but no one wants to talk about proper money management – it sounds rather dull.
Be that as it may, this “dull” subject is one that can’t go without proper consideration if you have hopes of becoming a successful Forex trader. So in the spirit of keeping the topic of Forex money mangement as light and entertaining as possible, I’ve broken it up into five key elements.
#1 Only Trade with Risk CapitalThis is the very start of where many traders go wrong when it comes to money management. It is imperative to your trading success that you only trade with risk capital, which refers to the funds you set aside specifically for trading. In other words, money that you can afford to lose.
If you are trading with money you need for bills or other basic essentials, your stress levels when trading the market will be unsustainable. Your emotions will get the better of you due to the need to make money. Instead of seeing what the market shows you, you will begin to convince yourself of setups that aren’t really there due to the constant pressure to make money.
Following this key to proper money management might mean starting with a smaller account size than you might like. Or, my personal suggestion, is to put money aside and only begin trading with that money when these three conditions are met:
You have fully developed an edge in the market such as price action trading
You have developed an unwavering confidence in your trading abilities
Your basic essentials in life are completely paid for by an income stream other than trading
Only when these three conditions have been met should you begin trading with real money. This will greatly reduce the stress you feel before, during and after a trade, which is the very start of an effective Forex money management plan.
#2 Cut Losses Short, Let Profits RunWe have all heard the saying, but how can we differentiate the two in the heat of the moment? It’s a great question and one worth examining further.
First and foremost, the best way to defend against losses is by developing a defensive mindset. Your job as a Forex trader is to always protect your capital, always! For those of you who play sports, you have probably heard the saying, “the best offense is a good defense”. This is as true to sports as it is to effective money management.
The most obvious way to cut your losses short is to always use a stop loss. In addition to using a stop loss, you should also maintain a proper risk to reward ratio on every trade. This combination is the easiest and most effective way of cutting your losses short and allowing your profits to run.
Last but not least, learn to listen to that little voice in your head. We have all been in a position that we knew was wrong from the start, but perhaps we were blinded by the potential for profit. More on this subject later.
Always remember that your first job as a trader is to protect your capital. Making money comes second.
#3 Don't Get GreedyIf you have been trading Forex for any length of time, I’m sure you have heard this saying. But what does it really mean? How can you tell the difference between “being greedy” and simply letting your profits run?
The very first rule of thumb is as follows:
Always plan your trade before entering the market. This will ensure that you are operating from the logical side of your brain instead of the emotional side.
For example, you enter a short trade with a 100 pip profit target. After 20 hours your trade is now just 10 pips from the target – the market has really started to sell off. Hoping for an even greater return, you move your profit target another 100 pips. The next morning the market is down another 50 pips; everything seems to be going your way. However when you check in later that day you find that the market has found support and has rallied back to your entry, wiping out your entire (unrealized) gain.
If you had simply taken profit at the level you had designated before entering the market, you would be walking away with a profit. Instead your best case scenario is a break-even trade.
Does this sound familiar? If it hasn’t happened to you yet, it will. It’s one of those inevitable lessons that every trader needs to go through to appreciate the importance of planning a trade before entering the market, and sticking to that plan throughout the trade.
So remember to always plan your trade ahead of time and stick to that plan no matter what. Do it before entering the market while you have a neutral mindset, because once you enter the market it’s far too easy for your emotions to get the best of you.
#4 Smaller is BetterPosition sizing is one of the most important aspects of Forex money management. Not just to protect your trading capital, but to help remove emotional decision making from your trading.
A famous trader once said, “be smaller than you need to be”. What this person was implying is that, a smaller position size will often result in a much more consistent track record.
By trading smaller position sizes, you will be less likely to make an irrational decision if the market moves against you. We have all been in a position where the market suddenly moves against us, only to reverse and continue in the desired direction. The traders who are trading too large of a position often panic during that sudden move and exit their position, leaving them with a loss instead of a win.
What is the first thing you think about when you wake up in the morning? If the first thought that fills your mind is an open position, then you’re probably trading a position size that’s too large for your account.
Be sure to always use a position size calculator when determining your position size. This simple tool will help preserve your capital and allow you to maintain a rational mindset when trading.
#5 Learn to Listen to That Little VoiceTrading with price action tends to be more discretionary than other strategies or systems out there. This is due to the fact that, although you may identify a pin bar at a key level, there are other confluence factors that can affect the probability of the outcome.
These factors often require some form of judgement by the trader. For example there are certain characteristics that can help determine the quality of a pin bar setup. While this level of discretion may sound like a bad thing, what’s interesting is that more often than not a trader knows the difference between an “A+” setup and a “B+” setup, even if it may not be immediately apparent.
I hear it from traders all the time. “I knew it wasn’t a perfect setup but but I was hoping the pin bar would hold”.
Sometimes it isn’t immediately apparent that the setup isn’t a great one, but there may be something about it that just doesn’t feel right. The best thing to do if you are ever unsure of a setup is to walk away and do nothing. Even if it’s just a gut feeling that “something” isn’t right.
Jim Rogers said it best when he said, “I just wait until there is money lying in the corner, and all I have to do is go over there and pick it up. I do nothing in the meantime.”
As human beings we have a multitude of senses including sight, hearing, taste, smell and touch. But there is a secondary set of senses, and among them is the sense of intuition. It will take some time to develop your intuition as a trader, but once you do it can be a difference maker.
Learn to listen to that little voice when it tells you that something isn’t right. Your intuition is a powerful asset that you shouldn’t be ignoring.
