Money Management: The Secret to Success in Forex Trading

 

 

By: Hillel Fuld
The foreign exchange market is unique in many ways. It is the largest market in the world with close to 3 trillion dollars daily. It is quite possibly the least regulated market as well, with anybody able to open a Forex position from the comfort of their own home or even on their mobile phone. It also enables individuals with very little capital to trade tremendous sums of money with the high leverage offered in the Forex market.

Another highly unique characteristic of Forex trading is that there is money to be made irrelevant of the state of the market. How is that possible? As opposed to other markets, traders can benefit from a currency going up or down. It is important to remember that while the stock market is essentially one sided, and if your stock decreases in value, you lose money, Forex is a two way street. Just like you can sell a currency at a high price and benefit from its increase in value, you can also buy a currency after its value has decreased and watch it closely while it makes you money.

This is of course a very attractive quality in today’s shaky economy. While other markets are suffering major consequences of the recession, the Forex market has not slowed down a bit, it is actually flourishing. This is yet another reason that the Forex market remains the largest market on the globe, by far.

These are all very important characteristics of the Forex market, but in this article, I would like to focus on something completely different, Forex money management. It would be interesting to conduct the following experiment. Have two non experienced Forex traders open opposite positions on the same currency; one will buy the EUR/USD while the other would sell. At the same time, have two experienced traders do the exact same thing. What would you expect to be the result of such an initiative?

The logical outcome of such a scenario would be that one side of each pair would profit, while the other would lose. If the USD would increase in value, the individuals who bought the USD would profit while those that sold it would lose. The issue of the trader’s experience might be irrelevant in such a scenario, after all, the USD does not care if the trader is an expert or a beginner.

This, as I expect, would not be the outcome of such an experiment. I am suggesting that the two beginner traders would both lose in the long run, while both experienced traders would profit. The obvious question is “Given that these traders are taking two opposite sides of a trade, how is it possible that they will both profit or lose?” As strange as this might sound, this phenomenon can be explained in two simple words: “Money management”.

It is true that in the short term, the two beginners and the two experts are trading against each other and one will profit, while the other will lose. However, in the long term, the beginner, who is new to the market, and does not know how to efficiently manager his/her account and trades, will end up losing the initial profit they made. The experienced trader, on the other hand, might lose in the short term, but with the use of Stop Losses, will make the money back and turn over some nice profits. Forex trading without money management can be a very dangerous endeavor. To illustrate this point, take a look at the below table that explains just how risky Forex trading can be.

 

 

  Amount of Equity Lost   Amount of Profit Necessary to Return to Original State  
25% 33%
50% 100%
75% 400%
90% 1000%

 


The numbers in the above table are crucial for any Forex trader. Just to emphasize, a trader who loses 50% of their capital, must make a 100% profit in order to return to their original state.

So, now that we know the numbers, and the average trader knows them too, why is it that traders do not practice money management with their Forex accounts? Well, the answer to this question lies more in the field of psychology, but similar to dieting or other challenging tasks, people are swayed by their emotions, and do not practice the discipline necessary to become a successful Forex trader. Just like in psychology however, traders begin to use money management techniques when they are burnt from a bad trade, similar to the way a child learns not to touch a hot oven. People need to learn the hard way, but once they do, they never forget the pain involved in that initial burn.

Now that we have established that money management is a crucial component of Forex trading, and we have delved into the world of psychology, let’s look to psychology again to learn how to manage your Forex account. There are two possible methods to implement in Forex money management, and the one you choose completely depends on the type of person and trader you are.

The first possible management technique depends on small profits with the hope that they will add up and overpower the larger losses you endured. The other option is to depend on the few major successes with the hope that they outnumber the larger number of small losses. The choice lies in the hands of the trader and should be determined based on that trader’s personality.

If for example, a trader can handle a few major blows to their account, while enjoying a large number of small wins, they should use technique one, and implement low Take Profits with higher Stop Losses.

Alternatively, if a trader feels that they cannot handle to lose a month's profits in one trade, they can use technique two and implement small Stop Losses with larger Take Profits.

In conclusion, it really does not matter what technique you use, nor does it matter what currency you buy or sell. The economy and the state of the world markets do not play an integral part of your personal profits either, when it comes to Forex trading. What matters is that you trade with great discipline, do not get greedy, or fall into the trap of overcompensating. Trade calmly, choose a technique for your trading and money management, implement it, and stick to it no matter what.