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Money Management in Forex Trading
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Tuesday, November 10, 2009 GMT
By: Terry Allen
Many Forex traders have difficulty understanding that their occupation involves a tremendous amount of risk. Good Money Management skills are essential in order to cope with this very serious problem.
Basically, money management strategy is a statistical tool that helps control the risk exposure and profit potential of every trade activated. The successful use and deployment of its concepts is a major factor that differentiates Forex experts from beginners.
As an example, one of the most simplest Money Management Strategies is the Fixed Risk Ratio which states that Traders must never risk more than 2% of their account on any single currency pair. The risk for each trade is kept within these parameters by correctly determining and evaluating its Position Size and Stop Loss.
Position Size is the amount of currency to be either bought or sold. Stop Loss determines the acceptable loss a trader is prepared to take. When inexperienced traders entered trades with just calculated profit targets, the results can be disastrous if they have also not clearly calculated a protective Stop Loss.
This simple Money Management strategy, combined with the following concept, makes it very amenable for beginners because it enables them to advance their trading knowledge in small increments of risk with maximum account protection. The important concept is ‘do not risk too much of your balance at any one time‘.
For example, there is a big difference between risking 2% and 10% of the total account per trade. Ten trades, risking only 2% of the balance per trade, would lose only 18% of the total account if all were losses. Under the same conditions, 10% risked would result in losses exceeding 65%. Clearly, the first case provides much more account protection resulting in an improved length of survival.
What are the most common psychological flaws of Forex novices that affect their money management decisions and lead to costly mistakes? Here are a few of them:-
Beginners quite often let opinions, theirs or those of experts, influence their trading decisions. Instead, their trades should be based on a sound money management strategy that advises both on well-defined loss protection and realistic profit targets.
Biting off more than can be chewed is a weakness of many new traders and derives from greed and a failing to have clearly defined trading objectives. Overconfidence occurs when traders think they have special information but this can lead to significant losses should this data turn out to be nothing more than just “hot-tips.”
Preferential bias prevents traders from analyzing properly new trading information that, in anyway, contradicts their already chosen path. In other words, they simply choose to ignore what the market is really doing.
Beginners do not understand that losing is a logical thought-out process rather than an emotion-based reaction and its acceptance and control are important parts of successful trading. New traders have a tendency to be more careless with profits then they do with their own invested money.
Beginners have a serious psychological tendency to ignore the downside risks to a trade instead focusing on the profits only. They have a tendency to think that each new trade will make them rich. They need to understand that they will earn more if they trade with realistic objectives.
Another concept that beginners need to appreciate is that the most successful Forex traders are first skillful survivors and second big earners. Top-class Money Management Strategies are very important weapons in the experts’ armory that allow them to achieve this goal.
Money Management Strategies should be used to help determine how good your trading system performs by determining its win:loss ratio and its resultant risk exposure. This is best done through the use of back-testing historical data. Automation is the best way to perform this task.
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