The second part of the money management article is here. Once again, our colleague Tung put down the key pillars of proper money management in forex trading. As we are primarily looking for great money managers, understanding all essential components mentioned in both articles is a key not only to manage your FTMO Account but to have a long-lasting trading career.
Money Management in Forex Trading
Forex Trading is a long and complex set of processes from planning, testing and executing a trade. Money management plays an essential part in whether a trader is profitable or not. Have you ever wondered what differentiates the losers from the winners? Or like myself, have you ever asked yourself, what do winners have in common? Once we look at statements published by different brokers, only around 20-30% of traders are profitable. Taking this into account, do you think that 20-30 % of traders have the same trading strategy, or do they all use the same set of indicators or do they have the same trading style? Well, I am pretty sure if you read those questions out loud, you may already know the answer, however, they all have something in common and that is good money management.
In the previous article, we have covered the basic and universal rules of money management in personal finance and as promised, I am bringing you the second part of money management and it is money management in Forex Trading.
In case you haven’t read the first part of money management, here is the link.
The biggest enemies – Fear and Greed
Just like money management in personal finance, in Forex Trading, it determines the winners from the losers, and as losing is part of the winning, with good money management we can maximize the winnings that will outperform the losses.
However, as money management goes hand in hand with other factors such as psychology, let’s discuss the biggest psychological barriers that keep you away from good money management.
First things first, your biggest psychological enemies are Fear and Greed. There are many types of fears – Fear of Missing Out, Fear of reversal, Fear of losing, fear of failure, and so on. While Greed is the only one, both fear and greed play a huge role in your decision-making when it comes to entering a trade or Executing a trade. Long story short, fear and greed are the main factors that hold you back from making the right decision to be disciplined and sticking to your system. As a beginning trader, you might have found yourself stuck in a situation where you did not know when it was the right time to enter a trade so every time the candle was reaching higher you would have entered a buy trade or vice versa. Or now while you are reading these lines, you are suddenly remembering the times when you did not know if it was the right time to exit a trade which had eventually led you to exit the trade earlier and thus not reaching your maximum potential profit, even though the joy and the euphoria from taking the profit were intense.
However, while you are now remembering the good times, you are also recalling the bad side of those actions and I am pretty sure that the bad side is much louder now. As per your calculations, the average losses of those trades hugely exceeded the average winning trades.
With that being said, once you start to see the slightest light in the tunnel, after all the losses you have absorbed, you have come to the point where there is no way around it, but to start implementing the money management. You are coming to a realization that the right money management is part of the winning trading strategy.
Money Management Rules in Forex
In this section, we will focus on the basic principles of money management. I know that this is the less exciting part of trading, but trust me, if you do it properly, your balance at the end of the trading period will shine brighter than ever before. Moreover, by applying these principles in your daily life, your decision will become more effective and you will be able to eliminate the significant psychological barriers.
Risk per trade
Risk per trade is basically the portion of your money or a percentage of your capital that you are willing to lose if things go wrong. In this section, we will not dive deep into mathematics using standard deviation, probability, a statistical measure of dispersion, and so on. What we will outline are the basic ideas of how much money you should risk in a trade. While it is alright to adjust the risk according to your setup, knowing the limits is the key.
My question for you to answer right now is, how much money are you willing to lose when a trade hits your Stop Loss? Now imagine that you have a 100,000 USD account under your management and you are starting to implement these ideas of money management rules in your strategy. If you set 10,000 USD as your Stop Loss, then you are basically risking 10% of your account. Now you might be thinking, why not risk 10 grands to potentially make 20, 30, or even 40 grands? And you might also think that 10,000 USD is nothing compared to 100,000 USD of your capital. If you think like that, you are already on the way to completely wiping out your account. That is a mindset of a gambler because it would only take you 10 consecutive losing trades and your hard-earned money is forever gone. Not only that, let’s look at the table below to find out the amount of money lost on your balance compared to the amount needed to return you back to your initial balance – to break even.
So you have lost half of your balance and now you have to double up your balance to break even. While it is not only too risky, but it also has a bad effect on your psychology. You might start to blame the pair that it was not performing the way you expected, you might start to doubt the broker, or even worse you might start to doubt yourself. Losing too much money can negatively affect your psychology and no doubt about it, however, the good news is, if you start implementing this basic rule, not only will you stay in the game longer but you will also start to feel more confident.
As the rule of thumb, never risk more than 2% of your balance. While it is just fine to risk 1% or even 0,5% and you can adjust individually to fit your setup, the limit is to never risk more than 2%. Now with that being said, risk-per-trade has to do a lot with your personality, either you take small losses to enjoy the profits from the large gains, or you make small gains but at the expense of big hits. It determines the type of a trader you are and that is a topic itself.
The risk to reward ratio
Another principle of money management in Forex Trading is the RRR or Risk-To-Reward ratio. This basically implies how much you are expecting your risk to earn you. The term also refers to a favourite saying among the traders, ‘cut losses and let profits run’.
Looking at the chart above, it is clear that implementing this principle in your strategy, the potential profit can exceed the potential losses, moreover, by focusing on the risk to reward ratio, you can eliminate the unnecessary negative trades by filtering out the best entries.
If you do not know what risk to reward ratio to introduce into your trading strategy, as the golden rule, you may start using RRR 1:2, and that won’t hurt at all. This implies that for each 100$ you risk, you will potentially make 200$. Usually as per RRR 1:1, for each 100$ that you risk, there is an expected return of 100$. However, as you go, you will find out that adjusting the RRR along the way is perfectly fine because as the market constantly changes, your strategy is then being constantly adjusted.
Risk management tools
Position size calculator
To help you precisely determine the exact risk per trade according to the instrument you have chosen, position sizing is an effective feature that will cut your time spent calculating the size of your trade. When you finally decide the percentage you are willing to lose on a trade, you are now left wondering how many lots are appropriate for a particular trade.
With the advanced technology, there are numerous position size calculators available online and what it basically does is based on the currency of your account, the size of your account, your risk ratio in %, Stop Loss in pips, and the currency pair you would like to trade, it will calculate how many lots of the particular trade you should enter.
For better visualization of a position size calculator, refer to the table below, or you can also download the free MT4 indicator here.
Stop Loss & Take Profit
Once you have set the size of your trade and the amount you are ready to risk, it is then time to set the Stop Loss and Take Profit to protect your money. By setting the Stop Loss you are not only protecting yourself from the events when a trade might go heavily against you, which might have a huge impact on your balance and thus on your psychology, but you are also practising discipline and being consistent which play a significant part in your success. We have seen a lot of adverse events in forex trading and although there were few lucky ones, the majority of those traders were heavily negatively affected. So make sure you always set a Stop Loss while entering a trade.
While it is very easy to enter a trade and let the trade do the work, adjusting the trade as it goes is an art that not many can master. A trailing stop loss is a technique used by a lot of traders. The main reason for the trailing stop loss is to secure the position against a loss in times of a significant reversal. It is basically when your trade is heading for profits so you move your Stop Loss closer to break-even to protect your balance from going into a loss when things turn around. You may also move your trailing Stop Loss to secure small amounts of profits when your trade is heading in a favourable direction.
Take Profit, on the other hand, secures your trades when they become profitable. We can say that it is an exit point, which we outline for a particular trade. While Take Profit is the opposite of the saying “…let profits run”, it, however, plays an important role in securing your profits when things can start to turn around as well.
Lastly, there is an application that I believe shall deserve to be one of the basic necessary tools for risk management and this tool is available to all the registered traders and is especially recommended to FTMO Traders. It is the in-house developed Mentor Application that works perfectly fine on MT4.
As we know how important it is to be able to closely monitor the Equity and the Limits, this application was developed by our IT team, and it allows you to track your own set of rules, therefore, you have a better overview of your results with reference to your Trading objectives. This forces you to not only be disciplined in your system but also prevents you from overtrading. So in case you are searching for an in-time, results-tracking, risk-managing, and with many other features & applications integrated into MT4 platform, feel free to check out Mentor Application here.
The final note
In this article, we have discussed the principles of money management in Forex Trading. While money management in personal finances is the way you distribute your net income, money management in Forex Trading has more to do with your risk and the way you manage risk, the only thing they have in common is that each has the basic rules and tools. How you are going to implement it into your trading strategy is another story.
In Forex Trading, one thing is certain: the market is uncertain, and that is totally fine. It is alright to be wrong at times because only when we are wrong we may find out that our trading strategy is not suited for a certain market, or that we need to adjust the strategy because a market might start to show different patterns.
Again, the most crucial part of money management is discipline. It will eventually show how consistent you are towards your goals in trading and to completely eliminate our biggest enemies – Fear and Greed, you must start focusing on managing your risk properly and follow your trading system.
With that being said, it is clear that before we even start researching the market conditions we need to have the right calculations in place. As trades can be heavily leveraged, it is important to implement money management principles such as the above-mentioned Risk per trade, RRR, and the right position sizing.
Now I believe that with all these basic principles of money management outlined in this article, you have a much clearer vision in how to approach your trades and although this part of the trading is the boring part for a lot of you, once you get it right, the profit that will come will be endless.