Money Management in Forex Trading: 10 Practical Tips
Money Management is one of the disciplines that novice traders are called upon to learn as soon as possible. It's a defensive tool, one of the few truly effective ways to limit the effects of a market that stands out for its complexity and unpredictability (despite technical and fundamental analysis).
Money Management is also a difficult discipline, especially in its advanced form. This article, after offering an overview of forex money management, provides 10 practical tips to apply it without complicating your trading. A complementary set of guidelines appears in online trading and money management.
Why Money Management
Money Management is the discipline that allows traders to maintain control over their capital, regardless of what may happen. It's a set of rules that let traders know in advance how much they can lose on any trade, and plan the potential gain against that. Its usefulness lies precisely here: in the ability to plan trades from a financial point of view.
Money Management produces two effects, both very beneficial. First, a technical and concrete effect. Thanks to Money Management, traders are truly able to protect their capital, also because they can avoid trades that even potentially can cause financial disaster. Or, at the limit, modify orders so that such a disaster cannot occur, or that not even a simple unsustainable loss can occur.
The second effect, no less important and decisive for the fate of trading, is psychological. Traders operate, basically, with a perennial feeling of uncertainty. This dynamic is structural, given the incredible unpredictability of money. Furthermore, it creates repercussions from an emotional point of view, reduces clarity and consequently also the effectiveness of trading activity.
But if traders put in place measures that give them back control over their finances, then the feeling of uncertainty decreases, and at the same time clarity and effectiveness increase.
10 Tips for Good Money Management
As already anticipated, Money Management is a complicated discipline. Of course, at a basic level it can also be approached by novice traders, but to make it truly effective it is necessary to put in place slightly more complex actions. Below are some of these actions, explained in a way that is understandable to most. For a broader set of practical pointers beyond money management, see 7 winning online trading tips.
Establish a maximum percentage of capital to risk on each trade
This is one of the fundamental rules of Money Management. It is also very simple to follow. Obviously, it is not the only one. In any case, when you decide how much to put on the line, do not risk more than 2%. That is, the loss you would take if the stop is hit should not exceed 2% of your capital; the size of the position then follows from the distance to the stop, not the other way round. If you can, halve the percentage. Also, contextualize the choice of trade size to the type of trading you intend to conduct. It is obvious: if you do Scalping, 2% is already an immense percentage and literally out of scale.
Pay attention to the "type" of money you invest
Money is not all the same, especially for those who hold it. Money is also characterized by its origin. Based on the origin, those who hold it use it in one way rather than another, with prudence or less prudence. This applies to all aspects of life, including trading. The advice is to keep this dynamic in mind, and to use only "quality" money, that is, money that means a lot. Now, what is the money that means the most? Obviously, the "earned" money, the result of any professional activity or that simply involved effort or fatigue.
The immediate corollary is therefore this: do not use borrowed money. The link with this type of liquidity is weak, so there is the risk of entering, certainly unknowingly, into a vicious circle, of establishing a dynamic characterized by imprudence.
Reserve a certain amount of money for exceptional events
In trading, especially in Forex Trading, things do not always go as planned. Indeed, almost never. Of course, some events are more difficult to manage than others. Moreover, there are events that are really difficult to manage, in front of which one can only defend oneself. Well, it is in these cases that a reserve matters: not to add money to a losing position, which is the mistake a later tip warns against, but to keep the account alive after a sudden and unforeseen loss has been taken and closed. Rebuilding the account is one thing; averaging down on an open trade is another, and the reserve exists only for the first.
Order, when it comes to Money Management, means predictability of expenditure. Hence the need to reserve a "special piggy bank" for particularly traumatic and unpredictable events.
Be more cautious when volatility increases
Obviously, if the period of volatility does not explode suddenly, and is somehow announced by various signals and events, it can be managed with greater effectiveness. It can even be exploited to generate profit, given the differentials that form in such a short time. However, if you care about your capital, and do not intend to overextend yourself, you should act with greater caution than usual. In terms of Money Management, this means above all reducing exposure. Traders who prefer to sit out choppier periods altogether can consult low volatility forex strategies.
The advice to follow is exactly this: if you find yourself in a period of volatility, but still want to enter the market, try to reduce your exposure.
Calculate the Stop Loss on profit prospects
This point may seem counterintuitive. Also because the Stop Loss is generally calculated on the prospects of loss. That is, the maximum tolerable loss is considered, it is translated into pips with respect to the entry point, and this number is subtracted from the entry point itself. It is, in fact, a method that works, although it is not the best possible method.
However, there is another parameter to consider, and this is exactly the profit prospect. It allows, in fact, to modulate the exposure.
The best advice that can be given in this case is to keep the potential gain larger than the potential loss: many traders aim for a ratio of 1 to 3, that is, three points of gain for every point of stop, and anything below 1 to 1 rarely makes sense.
Modulate positions based on trading frequency
This is a rule of common sense. If you trade frequently, reduce exposure per single trade. Frequent trading simply means placing many orders in a given time frame. Day traders trade frequently, and scalpers even more so.
The principle is common sense for at least one reason: if the frequency of market entry increases, the risk of making mistakes also increases. Risk is added to other risk. Now, one of the basic rules of Money Management, or more precisely of Risk Management (the two disciplines literally go hand in hand) consists precisely in decreasing exposure as risk increases. Therefore, take this dynamic into account and avoid the classic overextension.
Do not add to losing trades, and think twice before adding to winning ones
This is a tendency developed especially by novice traders, those who on the one hand are not yet able to manage negative emotions with sufficient effectiveness and who on the other have not yet accepted that losing trades are part of the job. This tendency manifests itself in the difficulty of "letting go of a trade". When the situation is unsalvageable, or saving it becomes even riskier, there is nothing left to do but withdraw.
Often, however, novice traders continue to replenish the trade, in the hope or the faint prospect that it will turn positive. This, to be clear, is detached from any technical evidence. In any case, it would still be wrong.
The same goes for trades that "turn out well". The first thought is the following: what's the harm in increasing exposure when a trade is making money? From a logical point of view, nothing to object to. From a technical point of view, and ultimately factual, it is all very risky. Firstly because the market can change direction even suddenly. Secondly, because Money Management is a prediction of gains and losses, but if an increase in exposure is improvised, this predictive character is lost.
Therefore, before replenishing a position, even if it is in strong gain, think about it several times.
Monetize gains immediately
As already anticipated, and as all traders know, the market is a complex entity, which hides within itself elements of unpredictability. An upward trend can become downward, a sideways phase can explode into a long series of declines and rises, or vice versa. It is precisely in these cases that Money Management, together with Risk Management, helps most.
The reference is, obviously, to Take Profit. Where the technical picture allows it, lock in the gain whenever you can. Always choose the path of caution, if you are faced with a crossroads and the analysis does not provide certain answers.
Do not trust your mind
The mind can deceive. Indeed, when undertaking a very stressful activity, in which emotional pressure reaches and often exceeds levels of tolerability, the mind almost always deceives. This is the case with trading and in particular with Forex Trading. For this reason it is necessary to rely on disciplines that put a bit of order in the investment activity, such as Money Management.
Do not trust your mind, therefore. If you have calculated a Stop Loss, turn it into an automatic Stop Loss. If exiting the market still depends on your decision-making ability, know that at the critical moment the risk of losing clarity is high.
In short, the "mental Stop Loss" could be disregarded, with all that this entails in terms of capital loss. Obviously, this dynamic also concerns the Take Profit, although in this case the risk is the missed profit (which can still be considered a loss, from a certain point of view).
Don't start with the most complicated rules
Of course, the ideal is to quickly achieve a mastery of the most refined variations of Money Management. After all, a more advanced Money Management allows for more effective protection, and more effective protection in turn expands the trader's margin of discretion and range of action.
However, as already anticipated at the beginning of the article, Money Management is also a complex activity. Therefore, it should also be approached with caution. Also because the dynamics that are at its base allow it. There is a certain modularity in Money Management. Of course, the basic rules offer effective protection only in the case of low-risk trades. The two things go hand in hand. However, proceed gradually, slowly but inexorably go through the learning curve.
A piece of advice: do not associate basic Money Management with risky trading. Money Management is not a smokescreen, a psychological fetish that serves only to reassure: it is a concrete resource, a tool that, certainly with gradualness, must be fully explored.
