Managing money (and risk) in your forex trading

Money management isn't just a nice catchphrase, it should be a the cornerstone of any forex trader's over-all strategy. Forexcrunch founder Yohay Elam gives some tips on how to make it part of yours.

As a forex trader, you have undoubtedly read about money management many times. Managing the risks inherent to trading should be something that is second nature to experienced traders, yet very few regularly apply it to their day-to-day forex trading. How do you change money management from just a buzzword into a key part of your trading strategy?

Any investment with high potential profits involves high risks. The key concept of money management is to be aware of—and take control of— your risk before taking any action. This can be an easy way to control your account, as well as help you avoid margin calls.

1. Never place a trade without a stop loss

 Putting a stop loss on any trade can help get you out of a situation where you might otherwise lose a lot on a single trade. You are probably reading this, thinking it is an obvious statement, but there are still traders who don't use a stop loss order. Even worse, this is also sometimes done by traders at forex brokerage companies with their clients' accounts. Sad but true.

2. Always be aware of how much money are you risking

 There are many methods of money management in forex trading. Most of them focus on a risk/reward ratio. Often it is 2:1, sometimes 3:1, which can sound good. But at the same time, many traders ignore just many dollars they are risking with each trade and whether it is too high. 

There are two way to potentially reduce the amount of money you are risking in your trades:

Set a tighter Stop Loss: While setting a tighter stop loss sounds like a strategy to lose less money in a losing trade, in reality it may not be your best move. Setting a tighter stop loss can in fact put your trade in a riskier situation. Lowering the money you are risking doesn't mean you should increase the chance of a stop loss being hit. It shouldn't depend on the amount of money risked.

Lowering the position size: A lower position size still gives you the option to place a stop loss at a level that is right for you while risking less money. However, the amount of reward also decreases. While most traders attempt to trade large positions, keep in mind that we are trading with leveraged money, not real money that we have on hand. By lowering the position size you still get to trade your full position, just with reduced levels of risk.

3. Account Risk 

By this point, you know how to monitor the risk of your forex account. But to be honest, have you ever thought of your burn rate? Let's suppose you start trading with $1000 USD. And let's say that for each trade, you risk 20% of your total capital. Guess what? It only takes five trades to blow up your account. And with new traders, it is not surprising to have five consecutive losing trades at a time. Risking large portions means you risk burning out your account quickly before you have had any chance to increase your winning rate.

Which brings us to the most important rule of thumb of money management:

Never risk more than 2% of your account per trade!

This may sound like an overly strict rule, but experienced traders know how important it is not to risk too much in one trade. The market is always moving and you will always have a chance as long as you have money to trade. Applying the 2% rule will help you stay in the market longer and accumulate sustainable profits in the long run.

Having a forex demo account is probably good for practice, but only by trading with a real account will let you feel the emotional stress of risking real money. But just by simply starting by applying the 2% rule in your trading strategy, you should start to see noticeable changes.