There are two kinds of Forex traders:
- Ones who make money.
- The other ones.
What separates them? It’s not brains or even knowledge. Lots of very smart people lose money in Forex trading. Most often, the problem is poor money management — holding on to losing trades too long, or taking best forex broker profits too early. Successful traders long ago reduced Forex trading money management to The Three Commandments of Forex Trading.
The First Commandment: Calculate the Risk-Reward Ratio
The first thing to consider in Forex trading is its risk-to-reward ratio. You must make sure the potential gain for a trade is greater than the potential loss. Therefore, use a risk to reward ratio of no worse than 1:2 – that is, risk only one pip of loss for every 2 pips of potential profit.
Why? Because you’re not going to be right every time. Forex traders who’ve spent years in the markets make plenty of losing trades, but because they use a favorable risk to reward ratio, their balances increase over time.
Of course, if you can find trades with even better ratios, like 1:3 or even 1:4, those are even more promising. In fact, if you use a 1:3 risk/reward ratio, you can lose on over 60% of your trades, and still see your balance increase.
One common approach to improving the risk/reward ratio in Forex trading is buying on dips.
Lets say the support line is about 100 pips below your entrance – that’s what you’re risking. Then go to the resistance line, 100 pips above your entry — that’s your reward. From a money-management standpoint, the risk to reward ratio here is horrible. You have about 100 pips of profit potential canceled out by 100 pips of risk.
To improve your chances, buy on the dip.
Enter here, and you’ve suddenly increased your upside and decreased your risk. The region for profit potential is larger, and if the trade reverses on you, you can get out with a smaller loss. The same principle applies when you’re shorting: in a downtrend, look to sell rallies to gain a better risk/reward ratio.
The Second Commandment: Use Stop-Loss and Limit Orders
Before you enter a trade, plan your exit. That’s what stop loss and limit orders are for. Using them, you choose a minimum profit target and a maximum loss target, and build it into the trade itself.
Amount of Equity Lost
Amount of Return Necessary to Restore Account to Original Equity Value
25% 33% 50% 100% 75% 400% 90% 1,000%
How much of your account should you risk in a single trade? This table shows some statistics for making up losses. As you can see, the further your equity falls, the larger and more unrealistic returns you need just to get back to break-even.
Many traders use 2% as a general rule. If your account balance is $10,000, then, the absolute most you should ever risk on a single trade is $200.
For example: You buy one lot of EUR/USD and enter the trade at 1.3600. You’re willing to risk $30 on this trade. With this currency pair, each pip the market moves is $1 of profit or loss. So if you set your stop order at 1.3570, 30 pips below your entry point, you are risking no more than $30.
And remember: stop means STOP. One of the worst mistakes I’ve seen new traders make is moving down their stops. They have become emotionally involved in a losing trade, and keep moving the stop to prevent the stop order from being triggered. Here’s what happens.
In that same trade, the euro falls to 1.3572. You fear your stop will be hit, and move it down 20 pips. It is now at 1.3550, and is still in danger of being hit. If it is hit, you will have lost $50 instead of your planned $30.
Another common mistake in is that new Forex traders often add to losing trades. They think that, even though a trade has already gone against them, if they continue to buy at a lower price they are getting a better average price for the entire trade. This just piles the losses higher. Add to a trade only when it’s going well. Don’t make a bad trade worse.
The Third Commandment: Never Overleverage
Always make sure that you have enough money in your account for trading the size you are doing. Too much leverage can quickly lead to a margin call and empty your account.
Suppose you have an account with $500.00. You buy 5 10k lots of EUR/USD. That’s a trade size of only 50,000 units. The margin requirement is $50 per lot, so your total margin requirement is $250 – half your balance!
That’s a hugely overleveraged position. Since you are trading 5 lots, every one-pip move means $5 profit or loss. So the market has to move only 50 pips – that’s just normal market retracement in this heavily-traded par – and you’ll get a margin call, which will close out all your positions.
Just like that, you lost $250, or half your balance — even though the EUR/USD did actually rise. Now, you’ll need to double your money just to break even. The currency just retraced a bit on the way, which is very common. Had the account not been overleveraged, you might have stayed in the trade, making a profit!
Now, for some better money management. There is a lot of risk involved in Forex trading so be sure you have an adequately funded account — for example, $5,000. Since you don’t want to risk more than 2% of your account on any one trade, you open 2 lots, which require only $100 of margin and leaves plenty available — $4,900. Even if your trade goes against you a whole 50 pips before being stopped out, your loss is only $100 (50 pips at $2 per pip). This leaves 98% of your account intact, with plenty of capital to take advantage of a better market opportunity later on.
Review The Three Commandments
- Always have a good risk to reward ratio of 1:2 or better. You can improve this by buying dips and selling rallies.
- Always use Stop orders, and risk no more than 2% of your account on any one trade. Once your stops are set, only move them UP, never DOWN.
- Do not Overleverage. A margin call can devastate your account.
- One More: Keep a Trading Journal
I hope you enjoyed this article on money management. A great way to start Forex trading is to open a micro account and trade one lot at a time. Once you’re happy with your performance, you can trade in larger sizes. We wish you success in your trading.
Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. Any opinions, news, research, analysis, prices, or other information contained in this article is provided as general market commentary, and does not constitute investment advice. FXCM will not accept liability for any loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on such information.