Money Management is probably the most important factor in trading. You have to realize that even the best trader in the world sometimes loses some trades. Not only can this be the result of a bad trade, but also because of unforeseen circumstances. The market can be quite irrational sometimes, and that is something you just have to accept. As more and more speculators enter the market, we see more special market circumstances than ever before. If you bet your whole account on one or a few trades, you will not be able to cope with loosing trades and you will blow your account before you know it. With good money management you will be able to absorb losses and get back on your feet soon enough. If you are a former poker player this must sound familiar to you, money management is an essential factor in poker too. Every poker player will see the cards turn against him from time to time no matter how well you play. With good money management this should not lead to any bankruptcy problems.
So how to do proper money management in forex trading? I will discuss this now.
 Trade your money one step at the time |
Limit Risk
It is important to limit the threat of one position to your account. It depends a little on your trading style, but you should keep the exposure of one position somewhere between 0.5% and 2% of your account. An intraday trader should be on the lower side of that range, a long-term trader could move a bit to the upper side.
Use Stop/Limit
Stop/Limits are important to cut your losses. They protect you from going bankrupt on a single trade. Make sure that before you take a position you decide on what level the position is proven wrong, and set your stop/limit at this level.
Risk / Reward
A very well known ratio in trading is the risk:reward ratio. It is essentially the most important reason for a trader to take a certain position. The ratio indicates the size of the reward that could possibly be gained by a position and compares this with the risk of the position. A general rule of thumb is that the risk:reward ratio must be at least 1:3.
Diversification
Diversification means that you should always check the correlation of the several positions you are holding. If this correlation is very much like 1:1 you should take this into account when you calculate your risk. For instance, the EUR/USD is very much correlated to the crude oil price. So if you buy the EUR/USD pair and crude oil at the same time, you are double exposed to a drop in the crude oil price.
Cope with losses
There will be moments that it looks like every trade you make, you lose. It is important at those moments to step aside from your PC for a while to cool down, and rethink the positions you have taken. A nice rule to keep in mind is that you have to step aside from you computer whenever you are 5% down on your account. Take a walk around the block and take at least a 30 minute break before you start trading again.
