Forex Money Management Rules
Incorporating money management techniques into your trading plan might take a bit of trial and error to see what works best for your trading strategy, account size and risk tolerance. Of course, any trading plan is only as good as the discipline a trader can muster in sticking to it. Quite simply, you should make sure you plan the trade, and trade the plan. As a good place to start, some of the more established guidelines for money management include the following:
Trade only with funds you can afford to lose. Since traders usually become emotionally stressed by losing money they require for the essentials of life — such as food, shelter or any other necessity that requires money — the best rule of thumb is to only trade with risk capital. This means only trade with money you can safely put at the risk of losing completely, since forex trading can result in the total loss of your trading account. This key money management principle will help you be less emotionally strained by losses sustained in your trading account and will allow you to exercise better judgment and think more strategically, which should benefit your overall trading performance considerably.
Assess risk reward ratios before trading. Before pulling the trigger on any trade, you really need to determine what reward you think the trade might reasonably be expected to achieve and what risk you are willing to take in order to obtain that reward. Suitable risk reward ratios to trigger trading can differ among traders with varying risk tolerances and trade criteria, and they will typically be included in a comprehensive trading plan. As an example, some active traders might use a risk reward ratio of 1:2. This means that they are willing to risk one unit of loss in order to make the two units of profit they are anticipating from the trade. On the other hand, more conservative traders might wait to execute a transaction until they determine a potential trade has a 1:3 risk reward ratio. The basic idea in setting a suitable risk reward ratio to use when trading is to filter out less attractive trades in order to only expose your trading account capital when better opportunities arise.
Choose a suitable position size. Traders need to set strict guidelines for the suitable amount to be traded given their account size. This helps protect the existing funds in their account from unanticipated trading losses. Some traders prefer to determine their trade amounts as a percentage relative to the amount of funds remaining in their trading account in order to conserve capital. Others traders might use the expected risk reward ratio on a trade to determine what size of a position they should take, with those trades for which they expect a greater reward for a given risk unit being taken in larger amounts. Still other traders might trade in a fixed amount or number of lots. All of these position sizing strategies can be used effectively to manage your money when trading forex, so choose one and apply it consistently.
Avoid risking all your capital at any given time. Many traders prefer to keep a large portion of their trading account funds in reserve so that they can recover faster from any significant losses, rather than putting all of their trading capital at risk at once. For example, a trader might avoid putting more than ten percent of their trading capital at risk at any one time across all their open positions. Thus, even if they suffer a full ten percent drawdown on the funds placed at risk, they still the remaining ninety percent of funds in the trading account. Putting a substantially large percentage of their account at risk might make fund recovery in the case of loss virtually impossible, or at least impractical, thereby effectively putting the trader out of business.
Know when to exit the trade before you enter a trade. The analysis performed before entering into a trade should give the trader a clear idea of where they expect the market to move to so that they can take profits on the trade, in addition to where they would cut their losses in the event of an adverse market move. This key pre-trade analysis will allow the trader to set appropriate take profit and stop loss orders for each trade when they are in a more objective state of mind. This important trade planning stage can really help traders avoid the lack of discipline when the time comes to either reap the rewards or take the losses as a consequence of their trading decision. Some traders might also set a time limit on their trades, so that the trade is closed out if the market does not perform as expected within a particular time frame. All of these decisions should be made ahead of time so that they can then be followed objectively rather than being influenced by the potentially problematic emotional states that commonly occur among traders when faced with decisions around trade management.