Even if you master every possible method of market analysis and will make very accurate predictions for future Forex market behavior, without a proper money management strategy you won’t make any money. Money management in Forex is a complex set of rules which you develop to fit your own unique trading style and amount of money you have for trading in the Foreign Exchange Market. Money management plays a very important role in making profits from Forex trading; do not underestimate it!

We are in the business of making money and in order to make money we have to learn how to manage it. This is one of the most overlooked areas in Forex Trading. Many Forex traders are just anxious to get involved in Forex trading with no regards to their total account size. They simply determine how much they can tolerate losing in a single trade and hit the “trade”button. There’s a term for this type of investing…it’s called GAMBLING!

When you trade in the absence of money management rules you are in fact gambling. You are not focused on the long term return on your investment. Instead you are only looking for that “jackpot.” Money management rules will not only protect us, but they will make us extremely profitable in the long run. Learn them!

Money management is something that most Forex traders pay lip service to, but few practice in real life. The reason is simple: money management can seem like a burdensome, unpleasant activity. It forces traders to constantly monitor their positions and to take necessary losses, and few people enjoy that practice. However, always remember that loss-taking is crucial to long-term trading success.

The Big One

Trading books are littered with stories of traders losing one, two, even ten years’ worth of profits in a single trade that has gone terribly wrong. Typically, the runaway loss is a result of sloppy money management, with no hard stops and lots of average downs into the longs and average ups into the shorts. Above all, the runaway loss is due simply to a loss of discipline on the part of the individual Forex trader.

Most Forex traders begin their trading career, whether consciously or subconsciously, visualizing “The Big One” – the one trade that will make them millions and enable them to retire young and live carefree for the remainder of their lives. In Forex, this fantasy is further reinforced by the folklore of the Foreign exchange markets. Who can forget the time that George Soros “broke the Bank of England” by shorting the pound and walked away with a cool $1-billion profit in a single day? But the cold hard truth for most retail Forex traders is that, instead of experiencing the “Big Win”, most traders fall victim to just one “Big Loss” that can knock them out of the Forex trading game forever.

Learning Tough Lessons

Traders can avoid this fate by controlling their risks through stop losses. In Jack Schwager’s famous book “Market Wizards” (1989), day trader and trend follower Larry Hite offers this practical advice: “Never risk more than 1% of total equity on any trade. By only risking 1%, I am indifferent to any individual trade.” This is a very wise approach. A Forex trader can be wrong 20 times in a row and still have 80% of his or her equity left.

In reality very few traders have the discipline to practice this method consistently. Most traders can only absorb the lessons of risk discipline through the harsh experience of monetary loss. This is the most important reason why Forex traders should utilize only their speculative capital upon first entering the Forex market. When novices ask how much money they should begin trading with, one seasoned trader says: “Choose a number that will not materially impact your life if you were to lose it completely. Now subdivide that number by five because your first few attempts at trading will most likely end up in blow out.” This too is excellent advice, and it is well worth following for anyone considering trading Forex.

Money Management Styles

Generally speaking, there are two ways to practice successful money management. A trader can take many frequent small stops and try to harvest profits from the few large winning trades, or a trader can choose to go for many small squirrel-like gains and take infrequent but large stops in the hope the many small profits will outweigh the few large losses. The first method generates many minor instances of psychological pain, but it produces a few major moments of ecstasy. On the other hand, the second strategy offers many minor instances of joy, but at the expense of experiencing a few very nasty psychological hits. With this wide-stop approach, it is not unusual to lose a week or even a month’s worth of profits in one or two trades.

To a large extent, the method you choose depends on your own personality; it is part of the process of discovery for each trader. One of the great benefits of the Forex market is that it can accommodate both styles equally, without any additional cost to the retail trader. Since Forex is a spread-based market, the cost of each transaction is the same, regardless of the size of any given trader’s position.

Four Types of Stops

Once you are ready to trade with a serious approach to money management and the proper amount of capital is allocated to your account, there are four types of stops you may consider.

1. Equity Stop

This is the simplest of all stops. The trader risks only a predetermined amount of his or her account on a single trade. A common metric is to risk 2% of the account on any given trade. Aggressive traders may consider using 5% equity stops, but note that this amount is generally considered to be the upper limit of prudent money management because 10 consecutive wrong trades would draw down the account by 50%.

One strong criticism of the equity stop is that it places an arbitrary exit point on a trader’s position. The trade is liquidated not as a result of a logical response to the price action of the marketplace, but rather to satisfy the trader’s internal risk controls.

2. Chart Stop

Technical analysis can generate thousands of possible stops, driven by the price action of the charts or by various technical indicator signals. Technically oriented traders like to combine these exit points with standard equity stop rules to formulate charts stops.

3. Volatility Stop

A more sophisticated version of the chart stop uses volatility instead of price action to set risk parameters. The idea is that in a high volatility environment, when prices traverse wide ranges, the trader needs to adapt to the present conditions and allow the position more room for risk to avoid being stopped out by intra-market noise. The opposite holds true for a low volatility environment, in which risk parameters would need to be compressed.

One easy way to measure volatility is through the use of Bollinger bands, which employ standard deviation to measure variance in price. Note that the total risk exposure of the position should not exceed 2% of the account; therefore, it is critical that the trader use smaller lots to properly size his or her cumulative risk in the trade.

4. Margin Stop

This is perhaps the most unorthodox of all money management strategies, but it can be an effective method in Forex, if used judiciously. Unlike exchange-based markets, Forex markets operate 24 hours a day. Therefore, Forex dealers can liquidate their customer positions almost as soon as they trigger a margin call. For this reason, Forex customers are rarely in danger of generating a negative balance in their account, since computers automatically close out all positions.

This money management strategy requires the trader to subdivide his or her capital into 10 equal parts. Regardless of how much leverage the trader assumed, this controlled parsing of his or her speculative capital would prevent the trader from blowing up his or her account in just one trade and would allow him or her to take many swings at a potentially profitable set-up without the worry or care of setting manual stops.

Conclusion

As you can see, money management in Forex is as flexible and as varied as the market itself. The only universal rule is that all traders in this market must practice some form of it in order to succeed.

Practice money management in Forex and succeed.