Money Management Essentials

Most people think of a trading strategy as a set of rules to define when to enter and exit the market. But that’s not enough—a complete strategy must also include a method to manage the risk to the account, which the trading community calls “money management.”

Let’s explore how to best construct and apply money management rules to maximize our chances of successful, profitable trading over the long term.

Why is Money Management Important? 

Money management is important because it preserves capital.

As Warren Buffet said, “Rule #1 of investing is don’t lose money.” Money management does not guarantee success in the markets, but it aims to give the highest chance of preserving capital, especially when market conditions are not in our favour.

Money management prevents a single trade from ruining my account.

Every trader will experience some losing trades.  For me, one of the most important things a money management strategy does is prevent a small number of losing trades from causing a loss so large that I cannot continue trading. Money management keeps me in the game, keeps me consistent, and lets my account grow. In short, by practising good money management, you can prevent an overall loss over the long term.

Money management is great for trading psychology and discipline.

I am a human being, so I experience emotions when I trade. Sometimes I get too confident. Other times, I want to avoid taking a loss because I am hoping the trade will turn around. Money management helps prevent this type of emotional trading which is one of the biggest reasons people lose their money in the markets.

What is Forex Money Management? 

“Forex Money Management” is a set of rules to manage the risk for each trade and the risk on the whole account. Sound money management rests on three principles:

  1. Reward/risk ratio.
  2. The percentage risk of each trade on the account.
  3. Maximum drawdown.

Using these parameters, I will know two hugely important things:

  1. How much each trade will cost my account if it goes against me.
  2. How many losing trades I can take before I should stop trading.

There are five practical money management rules that every trader should know and execute in their trading. Let’s look at them all below.

Rule 1: Only trade with funds you can afford to lose.

Trade only with “risk capital.” This rule is so important that most brokers have it as a risk disclaimer on their sites. I define “money I can’t afford to lose” as money I need to meet the financial obligations necessary for a minimum level of lifestyle. For example, I would not risk the money I need to pay my mortgage or make my car payments.

A good experiment to know if I am trading with money that I can’t afford to lose is to imagine losing it all. Is there anything I can’t do in my life afterwards? Can I take that loss and still meet my obligations?

Keep in mind that losing capital is still painful, whether it’s risk capital or not. This pain is a separate issue from whether it’s risk capital or money I can’t afford to lose.

Rule 2: Establish your risk to reward ratio.

This ratio shows how much a trade will risk compared to its potential reward. For example, a trade with a 50-pip stop-loss and a 100-pip target has a reward/risk ratio of 2:1.

Most successful traders risk less than their potential reward on a trade, in other words, they want a reward/risk ratio greater than 1:1. The reward/risk ratio is as important as the win rate. A high ratio, for example, 2:1 or 3:1, gives me the cushion to make money with a lower win rate. With an average 2:1 ratio, I only need a 33%-win rate to breakeven.

As a rule, I will never take a trade with less than a 1:1 ratio, but I prefer at least 1.5:1 or greater. If I see a trade with a 50-pip target, but the only place I can find for a stop-loss is 60 or 70-pips from the entry, I won’t take the trade.

I recently listened to a podcast with an independent self-funded trader from Sweden, Kristjan Kullamägi, who in 2020 turned $4 million to $32 million with only a 30%-win rate. To achieve those returns, he had very high reward targets compared to his risk (quantified by his stop loss orders).

Rule 3: Quantify your risk per trade.

When a trade goes against me, I don’t want it to lose more than a maximum percentage of my account. This is the most important rule to prevent one or two trades from destroying the entire account value. This rule also prevents emotional trading and risking too much, for example, if I’m desperate to make money or feel too confident.

How do I calculate the percent risk per trade?

Let’s say I have a $10,000 account, and my maximum risk percentage is 2%. In this case, 2% of $10,000 is $200. That means the value of my stop-loss cannot be more than $200 for any trade. If I have a trade with a stop-loss of 50 pips, my position size cannot be more than $4 per pip ($200 divided by 50 pips).

I place every trade at the same percentage risk to keep things simple. Some traders prefer to adjust the percentage on each trade while respecting a certain maximum percentage.

Calculating position size and leverage: use a calculator.

It can feel simpler to use a fixed position size on all your trades, for example, 1 mini-lot for each trade. However, I would then have different risk levels across different trades. A 50-pip stop loss will risk twice as much of my account as one with a 25-pip stop-loss if I use the same position size for each trade. This means I must adjust the position size according to the stop-loss. That may seem like a lot of hard work, but the calculations are easy if I use a position-size calculator.

As my account size changes, my position sizes will change.

The nice thing about using a percentage risk per trade is that if the account gets smaller, my position sizes will also get smaller. This makes it more difficult to take my account value to zero. If I have a series of winning trades, my position sizes will increase, and I can compound my account.

>Rule 4: Respect Leverage

Leverage is simply a borrowing mechanism used to increase the value of a trade. Forex is notorious for attracting individuals that want extremely highly leverage on their accounts. Traders will pick brokers and account types with the highest leverage even if the broker is not reputable or regulated adequately or has poor trade execution, customer service, or a whole menu of other problems. I see high leverage as an instant gratification drug—people use it as a shortcut without understanding its risks.

All Forex accounts need some leverage.

Forex trading requires leverage because the actual price movements between currencies are very small. Leverage allows us to capitalize on small price movements with a reasonable account size. So, I am not saying we should completely avoid leverage.

Leverage increases risk as well as reward.

Using leverage to Increase the potential reward of a trade means it also increases the potential risk. When I say, “respect leverage,” I’m more accurately trying to say, “respect the risk that leverage brings.”

Don’t use all the offered leverage just because it is available.

Leverage is an option but not an obligation to use. Some traders feel they should use all the leverage in the account and have every dollar in the market. That’s not the approach I recommend. Instead of focusing on using leverage, calculate how much a trade can cost the account if it reaches its stop loss. Next, ensure that cost is under a maximum pre-set percentage of the account.

Rule 5: Withdraw profits.

Some traders occasionally withdraw profits to keep a cushion of extra savings. It takes that money out of the market and de-risks it. Here’s an example: every time your account is up 30%, you could withdraw 5% to 10% of the account size.

The downside of regular withdrawals is it slows down compounding growth.

I consider withdrawing profits an optional money management rule (and all the other rules I consider mandatory). Deciding whether to withdraw profits will depend on the size of your trading account compared to other savings. If you start with a $1000 account but have more than $10,000 in cash saved elsewhere, you may not worry much about withdrawing profits.

Bottom Line

 

Money management is a set of rules to manage the risk to your account. The main principles of money management are trading with only risk capital, having good reward/risk ratios, and setting a maximum percentage risk per trade and drawdown level on your account. You can also periodically withdraw profits to protect some of your winnings.

Money management is an essential part of any complete trading strategy. It preserves capital and prevents a small number of trades from disproportionately damaging your account. A trading strategy is not complete without money management.

FAQs 

Why is money management important in trading?

Money management controls the risk to your account to preserve capital and prevents a small number of losing trades from disproportionately damaging your account.

What are money management strategies?

Money management strategies include trading with only risk capital, keeping good reward/risk ratios, setting a maximum percentage risk per trade, setting a maximum drawdown level on your account, and occasionally withdrawing profits.

How is money management used in Forex trading?

In Forex trading, using Money management means adjusting your position size to an appropriate level while considering leverage, so trades do not risk more than a certain percentage of your account.

How do you set up money management in Forex?

Set up money management in Forex trading by having good reward/risk ratios and using a position size calculator after deciding the maximum percent risk per trade.

What are the types of money management?

The types of money management include calculating position sizes, so trades do not exceed a percentage of your account if they get stopped out, keeping good reward/risk ratios, and having a maximum drawdown level on your account.

Huzefa Hamid

I’m a trader and manage my own capital. I trade the major Forex pairs, some Futures contracts, and I rely entirely on Technical Analysis to place my trades. Today, I am also a Senior Analyst for DailyForex.com. I began trading the markets in the early 1990s, at the age of sixteen. I had a few hundred British pounds saved up (I grew up in England), with which I was able to open a small account with some help from my Dad. I started my trading journey by buying UK equities that I had read about in the business sections of newspapers. The 1990s were a bull market, so naturally, I made money. I was fortunate enough in my early twenties to have a friend that recommended a Technical Analysis course run by a British trader who emphasized raw chart analysis without indicators. Having this first-principles approach to charts influences how I trade to this day.

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