What is forex money management?

So, you’ve read a forex book and an online article or two, honed your skills by paper trading, developed and refined a trading strategy that makes sense, and scraped some capital together. You’re not quite good to go, though, unless you’ve got some idea about money management: how you’ll actually manage the cash in your forex trading account while making investments. 

The basic idea is not to pursue profit helter-skelter but to preserve your trading capital. You may not win all the time – which is impossible, anyway – but you do want to make money on average and in the long run. Forex money management is therefore closely tied to risk management strategies and aims to minimise trading losses, when these inevitably occur, so that they can be absorbed without too much pain. You can never know which trades will turn out to be losers; that’s a given. As long as you make a profit on other trades, though, you should still come out ahead – without first seeing your account balance reach zero.

As mentioned, knowing something about risk management is a prerequisite for practising good money management when trading forex. However, this is not enough, as the definitions of these two concepts are slightly different. Specifically, risk management is about preparing for and managing all identifiable risks – doing so can include things as arbitrary as having a backup computer or internet connection. Money management for forex traders, on the other hand, relates entirely to how you plan to use your money to grow your capital without putting it at undue risk.

How do I stop losing money in forex?

This is precisely the question that forex money management will help to answer. Since we are all human and tend to have similar traits – positive and negative – there are a few common mistakes to avoid in forex and in fact in trading generally. Steering clear of obvious blunders can be thought of as the first step towards better money management.

Clearly, when your account balance hits rock bottom, it’s “game over” for you until you earn more investment capital somehow. This has, regrettably, happened to far too many novice forex traders. Part of the game is the possibility of losing all your money, as with any investment where your funds are put at risk. As an investor, it is your own responsibility to minimise the chance of that happening.

There are indeed ways to fine-tune your trading strategy in order to win more and lose less, but that is not normally the main reason people lose money in forex. Having no specific money management plan in place is a far more common cause of ruin. 

Some of the rules below are somewhat debatable or open to interpretation. If you choose to ignore any of these time-honoured practices, though, you should at least have a cogent reason for doing so.

The 5 forex money management rules for success 

As long as you get these five cornerstones of money management right, your odds of being successful at forex trading will improve greatly. These rules can be tweaked or tailored to your own trading system, but some version of each of them should be written down and read through, as a kind of checklist, before every single trade is placed.

One: Define risk per trade using position sizing

Except in the most extraordinary of circumstances, a wise trader will risk only a small percentage of their total account balance on any one trade. Trading mentors often preach the “2% rule”, by which a trader should risk no more than 2% of their capital on any trade. The math isn’t especially hard: if you have $10,000 in your trading account, limiting yourself to a possible loss of $200 per trade insulates you from the consequences of possible bad decisions. 

A good trading strategy combined with a sound risk management plan should help a trader make money over time, but there’s never any guarantee of making a profit in the next trade or even the next ten trades. To mitigate the chance of any given trade resulting in a crippling loss, it’s best to keep trade sizes relatively small compared to the size of the account. 

By logically extending this principle, you also protect yourself against several losing trades in a row by making the amounts risked small enough that even multiple consecutive losses remain something you can quickly recover from. A run of bad luck, or trading under market conditions you don’t have any precedent for, shouldn’t be enough to wipe you out.

Two: Set a maximum account drawdown across all trades

In forex, drawdown is defined as the difference in account value from the highest the account has been over some period and the sum remaining after some losing trades. If a trader had $10,000 in their account at the beginning of the month and then lost $500 by the end, they have suffered a 5% monthly drawdown. The larger the drawdown, the harder it is to recover the amount lost with trades that do make money.

Source: trade-leader.com

Traders will set an acceptable maximum drawdown level by backtesting their trading strategy. Let’s say some trader reviews their performance over 50 trades and determine that the greatest drawdown they’ve seen was 6%. In this case, they might set 6 or 7% as their max allowable drawdown. Now, if all their open trades risk draining their account by more than 7%, their new money management rule would kick in, obligating them to close some or all the trades to put their trading portfolio back into good order.

Three: Assign a risk/reward ratio to every trade

The rule of thumb taught in most trading textbooks is that a trader should aim to have winning trades that are, on average, twice as big as their losing trades. In other words, they should strive for a 2:1 risk:reward ratio. When this rule is followed, a trader needs only a third of their trades to succeed in order to break even.

In actual fact, the specific risk:reward ratio chosen is less important than following it as consistently as possible. It’s a good idea to be mindful of the math involved: a trader who chooses a risk:reward ratio of 1:1 has to win at least half of their trades to show a profit. If they decide on a more conservative a risk:reward ratio of 3:1, getting 1 in every 4 trades right is all that’s required to not lose money.

Source: freeforexcoach.com

To get consistently favourable trading results, a forex trader must have some idea of what to expect from his or her trading strategy. Two important and complementary components of making money in the long run are the win:loss ratio and risk:reward ratio, both of which can be established by backtesting with historical trade data. 

Four: Use a stop loss and take profit order to plan each trade exit

Using a stop loss locks in the maximum amount a trader can lose in any one trade, while using a take profit order locks in the maximum amount the trader can win. Either can, potentially, limit your upside, but the protection they offer against unexpected downturns makes them worth it. By using these forex order types, the conscientious trader can make sure that they do not suddenly find themselves locked into a position that loses more money than planned.

Of course, you will occasionally see a stop loss triggered only for the trade to quickly turn around and hit the take profit level. Still, as annoying as that experience might be, it is worth applying a stop loss for those occasions when the price does not turn around quickly and leaves you with an unmanageable loss.

Five: Only trade with the funds you can afford to lose

It’s never not worth repeating: successful trading is only possible when a trader can keep a cool head and make unemotional decisions based on opportunity, risk, and potential profit. Anyone who “needs” a particular trade to win to recover money lost elsewhere is highly unlikely to make sound decisions. The only likely outcome is to end up losing more money than can be attributed to bad luck or poor information.

If you find your trades being driven by motivations like greed or fear, you’re better off shutting down the computer and heading for a casino or racetrack instead. The best advice is to “hope for the best and plan for the worst” by restricting your trading to amounts that would not hurt your lifestyle if you lost the entire contents of your forex trading account.

Can I trade forex with $100?

Let’s finish up by answering a common question from those who’d like to get in on the forex action, particularly younger investors who have a small amount of money but would like to try their hand at trading, if only to gain some experience. 

It is certainly possible to trade with $100 using any of a variety of online brokerages. However, working with such a small sum is actually harder, and money management becomes even more important. In this instance, the trader would use “micro lots”, in which each trade is worth around $1,000 and each pip means a profit or loss of around $0.10. This would mean that the trader must place a maximum stop loss of 20 pips, equivalent to $2, if they want to keep to the 2% rule for positioning sizing. When you have more capital to trade, it provides you with more room to manoeuvre and adds flexibility to your money management strategy, increasing the odds of being a profitable trader. 

So, if $100 is all you can afford to risk right now, by all means go for it. However, it should be understood that this isn’t enough to practise all aspects of forex trading. Signing up for a trading simulator may be a better use of your time.