How to Manage Risk in Your Forex Trading Account
Forex Money Management Defined
It is universally accepted that Forex money management is a set of processes that a Forex trader will use to manage the risk in their Forex trading account.
Successful Forex traders tend to accept the adage, “If I’m right on the entry, the upside will take care of itself. If I’m wrong, the downside or losses can be unforgiving.”
The underlying principle of Forex money management, or for that matter, any speculative investment, is to preserve trading capital. This doesn’t mean you won’t have any losing trades because that is impossible. The objective of Forex money management is to minimize trading losses so that they are “manageable”. That means keep your losses small and try to manage a winning trade to get the most profit out of the move.
Essentially a successful Forex trader doesn’t necessarily have more winning trades than losing trades, but rather the dollar amount of his winning traders are consistently bigger than the dollar amount of his losing trades.
The concept of money management is often used interchangeably with the term risk management. However, they are not the same. Risk management is about preparing for and managing all identifiable risks – that can include things as arbitrary as having a backup quote service or charting program. Money management, on the other hand, relates entirely on how to use your capital to grow your trading account balance without putting it in a position to risk it all.
How to Best Avoid Losing Money when Trading Forex Markets
The implementation of a Forex money management plan may be the best way to try to avoid losing money in the Forex market. No trading system is perfect nor are humans, or even robot traders. They all have similar traits (good or bad), but collectively, they do share common mistakes. These common mistakes are the ones that successful traders strive to avoid.
Successful Forex traders tend to think of trading as a business. In that business, there will be profitable trades and overall profitable days, but there will also be losses. Once again, if you want to stay in business then your profits are going to have to be greater than your losses. And once again, we are not saying that you can’t have any losses.
It is important to say at this time that yes, you can lose all your money in any investment where your funds are put at risk. So it is your job as trader/business owner to minimize the chance of that happening.
There are ways to fine tune a trading strategy i.e. optimal entry and/or optimal exit, tighter, well placed stop losses or identifying better profit objectives, with the goal to win more and lose less.
But that is not usually the main reason traders lose money in the Forex markets. The main reason tends to be having no specific money management rules to follow. Here is a list of the rules that top Forex money managers tend to follow.
Top Forex Money Management Rules to Follow
Define Your Risk Per Trade Using a Position-Sizing Model
The idea behind this rule is that a trader should risk only a small percentage of their trading capital on any one trade. Several books or papers on Forex trading preach the ‘2% rule” where a trader should risk 2% of their account on every trade.
This ‘Fixed Percentage Risk’ can actually be any amount you are comfortable with and can afford.
If your trading account has a $50,000 balance then 2% of that amount will be $1000 of risk per trade.
A $1000 risk per trade may be a huge amount to a trader with a balance of $5000 in his account. In this case, 2% risk will be $100 of risk per trade.
The reason you’ll want to risk a fixed percentage is because if the first trade is a loss then the next trade will carry a smaller amount of dollars at risk.
Taking a smaller amount of risk following a loss will allow you to ride out a losing streak longer than an individual who risks the same amount on every trade. This will buy you time and allow you to have a big enough balance to perhaps start a willing streak.
Know Your Maximum Drawdown Level
A drawdown is the difference in account value from the highest the account balance has been over a certain period and the account value after some losing trades. For example, if a trader begins with $5000 in his account and she loses $1000 then she has a 20% drawdown.
The larger the drawdown, the harder it is to become profitable.
Following a 20% drawdown, a trader would have to make 25% in the market just to get back to even. If your trading system has never shown that kind of return over a reasonable time period then your maximum drawdown rule will tell you to stop trading.
At that point, you can reevaluate your trading strategy. You can lower your fixed percentage of risk, but most of all you can relax and breathe again, allowing you to regroup and reload after you have learned from your mistakes.
Assign a Risk/Reward Ratio to Every Trade
The generally accepted rule in the trading industry is that traders should aim to have winning trades that are on average twice as big as losing trades. With this risk:reward ratio, the trader need win only a third of their trades to breakeven.
The mathematics behind this rule says if a trader choses a risk/reward ratio of 1:1, then the trader must win a higher number of trades (at least 6 out of 10) trades to be profitable. If the trader chooses a risk/reward ratio of 3:1, then they need to win fewer trades (1 in every 4 trades) to break even.
It should be noted that this rule works great on paper, but in reality a trader really has little control of the actual risk/reward he will achieve on a trade.
Furthermore, a trader may be able to control is losses through stops (provided there is no slippage), but at the same time, a trader could cut his profits by not allowing a winning trade to end naturally, for example, by hitting a trailing stop.
The best trading strategy tends to cut losses and let profits run. Over the long-run you’ll get the actual risk/reward ratio.
Essentially, a successful trader has larger average wins than average losses. The bigger the average win, the less a trader has to worry about having a high percentage of wins. For example, you can have 90% accuracy, but if you average loss is $50 per trade and your average win is $10 per trade then one average loss will wipe out 5 of your winning trades.
Use a Stop Loss and Set a Profit Objective
Using a stop loss locks in the maximum amount a trader can expect to lose in any one trade, while a profit objective order locks in the maximum amount the trader can profit.
Don’t just use dollar stops. Place a stop in a place where you are wrong on the trade.
Additionally, if your strategy has been tested for fixed profit levels then follow the rules. If your strategy calls for trailing stops to lock in profits then follow that strategy. Try to avoid mixing your exit strategies because it can skew the risk/reward ratio your trading system needs to be profitable over the long-run.
Remember, in order to be successful, you’ll need to have a few big winners to offset a series of small losses.
Only Trade with Risk Capital
Successful trading is only possible when a trader can make unemotional decisions about what to do when a trading opportunity presents itself.
If you are undercapitalized, you will trade scared. If you trade scared then you will cut corners which could be trading without a stop, taking profits too soon, doubling down on a losing trade or putting yourself in a position too big to handle. If you do any of those things then you limit your chances of success.
Only trade with money you can afford to lose.