In the context of trading, money management involves managing your trading capital efficiently and effectively by implementing techniques and strategies to limit risk with the goal of increasing your reward at the same time.
This proficient use of money and risk management is often the difference between being a successful forex trader or not. It allows you to protect your hard-earned capital whilst optimising your overall trading performance. Frankly, it is possible to have two different successful traders, trading the same market and currency pairs but trading opposite directions (one going long and the other going short), and both ending up making a profit out of their trade. Despite the contradiction, this can be achieved through the use of proper money and risk management.
If one does not practice strict money management, it will be close to impossible to make money in the financial markets as the risk of ruin and blowing an account will increase indefinitely. In this sense, without proper management of risk, the act of trading will more likely resemble a form of gambling rather than any responsible means for surplus acquisition of capital.
Proper management of risk can be achieved by prioritising position size, stop losses, profit targets and risk/reward ratios, to mention but a few. Such tactics will help to protect oneself from the ebbs and flows of the market and any emotional and psychological factors one may encounter whilst trading (such as fear, greed, stress, frustrations, etc…).
| Amount of Equity Lost | Return Needed to Yield Original Equity |
| 25% | 33% |
| 50% | 100% |
| 75% | 400% |
| 90% | 1,000% |
Unfortunately, drawdowns and losing streaks happen quite frequently in forex trading –and it is proper money and risk management that aid in limiting the downside. And the greater the downside, the greater monumental feat it would be to regain one’s performance into a profitable one. Taking a look at our figures above, with a 50% drawdown, we would need 100% returns just to bring our account to its original equity. And the more we lose, the tougher it gets.
Example:
Starting capital = €10,000
Amount of equity lost = 50% = – €5,000
Return Needed to Yield Original Equity = €5,000 into €10,000 = 100%
Some suggestions for effective money management:
- Only trade what you can afford to lose. Losses are part and parcel of trading and unfortunately, a number of forex traders will realise that they have made more losses in their careers than profit and will decide that the trading game is not for them. For this reason, it is advised not to risk more than one can afford. Instead, it would be wise to choose a number that will not materially impact your life if you were to lose it completely.
- Use a stop loss. Consider at which point you are willing to leave a trade when it is going against you and have the discipline to execute accordingly. Similarly, don’t overreach when profit target is hit. When gains are satisfactory, consider at which point you are willing to close a trade at a profit before it starts moving in the opposite direction.
- Quantify your risk per trade. This may be as a fixed sum (for example, no more than €50 per trade) or as a percentage (for example, no more than 1% of the account balance). By only risking a small amount per trade, one can be indifferent to the result of any individual trade. As mentioned above, losing streaks happen. For example, with risking just 1% of total equity per trade, a trader can get it wrong 10 times in a row and still have 90% left of their equity.
- Set limits. Similar to the point above, a trader can set certain limits to aid in trading. For example, stop trading if you have 3 losing trades in a given day, or stop trading if you lose more than €100 per day or €500 in a week.
- Establish your risk to reward ratio. There are mainly two ways to practice successful money management with respect to a trader’s win rate. A trader may take numerous small stops and try to make as much profit as possible from a few large winning trades (low risk-high reward with a low win rate expectancy), or a trader may choose to go for various smaller gains and take occasional but large stops with the hope that the many small profits will outweigh the few large losses (high risk-low reward with a high win rate expectancy).
- Respect Leverage. Leverage is an important tool which allows forex traders to open larger positions than their capital would otherwise allow. For example, if a trader has leverage of 1:30, they can open a position worth €30,000 with just €1,000 in their account. This is a great advantage as it creates the opportunity to magnify profits by allowing access to larger positions with less capital available. But traders need to be wary as the greater the leverage, the greater one’s risk. So in the same way that leverage helps to amplify profits, it also amplifies one’s losses. For this reason, it is important to treat leverage with much respect and care.
- Avoid taking unnecessary trades. Overtrading and revenge trading should be avoided at all costs. Trade your system only. Do not take a trade if your desired setup is not in place. If you have had a losing trade or sequence of losing trades, consider scaling down your trades rather than taking revenge trades to make back your money, as this may lead to disaster. Capital preservation is critical to stay in the game and should always be the first priority over simply making money at all costs.
Whilst novice traders often discard the importance of risk and money management, they are key to one’s success in the financial markets. One’s capital is his/her working tool in trading and therefore all necessary measures are to be taken in order to protect it. For it is often not one’s decision to buy or sell that causes them to lose in the long-run, but poor risk and money management.
Unfortunately, losses are an integral part of trading and if a trader does not accept losing, winning in the forex markets is basically impossible. A trader can’t always be right. S/he may have the best analysis possible, but it is ultimately down to the market to decide which way it wants to be heading. It is therefore through adequate risk and money management that a forex trader can stay ahead in the market, protect precious capital and be in a chance to succeed in the long-term.