The knowledge of Money management in forex trading is one of the most important aspects of trading. Sadly, the lack of proper money management is one of the major reasons why forex traders keep losing money.
Managing money is vital in every business, and forex trading is no different.
To become a successful forex trader, you must nail the concept of money management.
For this reason, you must understand the difference between money management and risk management in forex trading; although closely related, they focus on different aspects of trading.
Difference Between Money Management in Forex and Risk Management
Money management is more about the tactical decisions for individual trades and maintaining the health of your account balance over time, while risk management is about understanding and mitigating the broader risks associated with trading in the forex market.
Money Management refers to measures that help a trader preserve their capital and grow it responsibly.
This involves determining how much of the trading account to risk on each trade, diversifying the trading portfolio, managing leverage, and implementing a plan for taking profits.
The ultimate goal of money management in forex is to increase profitability and reduce the risk of substantial losses. In addition, it requires discipline and helps traders survive in the long run.
On the other hand, risk management involves identifying, assessing, and controlling the various types of risk associated with forex trading in general.
This includes market risk (unexpected market movements), broker refusing to honor your trading positions, and operational risk (risks associated with trading operations like technology failures).
The main purpose of risk management is to protect the trader’s capital from significant losses due to unforeseen events.
Now, Let’s Get to the list of the best Smart Money Management strategies That can help you minimize losses and maximize profits.
- Difference Between Money Management in Forex and Risk Management
- Trade With Enough Capital
- Practice Risk Per Trade Rule
- Understand Trade Management
- Understand The Best Times To Trade
- Have a Trading Plan
- Diversify Your Trading Portfolio
- Keep Emotions in Check
- Reviewing Your Trades
- Practice Risk Capital Rule
- Use Leverage Wisely
- Continuous Learning
Trade With Enough Capital
The size of an account greatly influences your money management strategy. An account size of too small will breed certain acts of desperation.
Enormous gains are desired, so traders go ahead to overleverage. Ideally, a trader with an account of 100$ should not risk more than 4 dollars per trade. Doing this leaves a margin for error while keeping your emotions at bay.
The truth is that you need enormous capital to reduce losses and manage risks efficiently. What is the optimal capital you should be looking at when trading forex? Click here to learn more.
Practice Risk Per Trade Rule
Risk in forex refers to a portion of your account on the line for each trade. Each trader has to choose a risk for their every trade.
It has to be ensured that this is an amount you can afford to lose. This is necessary so market psychology is not affected.
I would advise a risk of 3% at most; whatever risk percentage is settled for, stick by it always.
Before entering each trade, the potential win and loss should be determined. The possible loss is the “risk,” while the potential gains are the “reward” for that order.
At least, the risk to reward for every order opened should be 3:1. This way, only high-quality trades are taken, and losses can be easily covered when things go south. Of course, scalp traders do not have to abide by this rule.
Many traders place a stop loss of 30 pips for a gain of 20 pips; this practice is bad. Sooner or later, you’re bound to get burned this way.
A good analogy for this is a coin flip for a possible gain. It’s difficult to guess if it lands either on its head or tail. The risk to reward, in this case, is 1:1; gambling (obviously).
Understand Trade Management
Experienced forex traders use either fundamental or technical analysis to attain a bias before an order is opened. After this order is placed, it does not stop there. The trade has to be managed to ensure either profit is secured at the right levels or the bias is invalidated.
First things first, a stop loss should be used at all times. As mentioned prior, a consistent risk should be used whilst ensuring a risk-to-reward of at least 3:1 is maintained, and this is why:
For instance, two consecutive losses were taken. On the third trade, a take profit of 1:4 was hit.
A forex trader with consistent risk broke even and made a bit more to top it off.
Let’s take a look at a trader who over-leveraged on his first two losses. Due to fear, on the third trade, he reduced his lot size because of fear. In this case, the gains would not cover the loss.
It is so important to have a standard risk in your trading plan. It improves returns and trading psychology as a whole.
Also, when three losses are taken in a row, take a break from the charts to clear your head.
Lastly, don’t be greedy; take partial at certain profit levels. Worst case scenario, employ a trailing stop loss.
Understand The Best Times To Trade
Keeping the feeling of “FOMO” (fear of missing out) in check will help to avoid losses. As the saying goes, quality over quantity. Remember, you cannot lose money if you don’t trade.
Choose a market session that suits your time zone/ schedule. In the forex market, there are three major market sessions, namely, the New York session, the London session, and the Asia session.
During the Asian session, market movements stall, bringing forth consolidation. However, XXX/JPY pairs are exempted from this action. It opens from 12:00 AM to 9:00 AM UTC.
On the other hand, the London and New York sessions are the best to trade. The majority of traders open and close orders during this period, so there’s an influx of liquidity, so either of these windows will do just fine.
They open/ close at 7:00 AM-4:00 PM and 1:00 PM-10:00 PM, respectively. The period when both of these periods are active is called the overlap, and the forex market is most volatile here.
Have a Trading Plan
“A trading plan is an organized approach to executing a trading system that you’ve developed based on your market analysis and outlook while factoring in risk management and personal psychology.”
It is a set of guidelines or rules that govern your entire thought process before executing a trade, during, and even when closing a trade.
For a trading plan to work, it has to be followed strictly. Also, as refinements to your trading strategy are made, they should also reflect in your trading plan.
Diversify Your Trading Portfolio
Don’t put all your money into one pair or type of trade. Instead, diversify across different currencies and trading strategies to spread your risk.
As the saying goes, do not put all your eggs in the same basket.
For instance, instead of focusing solely on EUR/USD, you could trade a mix of pairs such as EUR/USD, GBP/USD, USD/JPY, AUD/USD, and USD/CAD.
This helps to spread the risk because even if one currency pair performs poorly, another might be doing well.
Also, employ various trading strategies. For example, you might use a trend-following system for some trades and a range-trading strategy for others.
You might also diversify using short-term (like day trading or scalping) and long-term (like swing trading or position trading) strategies.
Keep Emotions in Check
Forex trading can be emotionally charged. It’s crucial not to let emotions like fear or greed drive your trading decisions. Instead, stick to your plan, no matter what.
Let’s consider two common scenarios:
Scenario 1 – Fear: Imagine you are a trader who just experienced a few consecutive losses. You’ve analyzed a new trading opportunity that aligns perfectly with your trading strategy, and it’s time to place the trade according to your plan.
However, due to recent losses, you feel afraid and decide not to enter the trade, thus deviating from your trading plan out of fear. In this situation, the emotion of fear has prevented you from making a potentially profitable trade.
Scenario 2 – Greed: Conversely, consider a situation where you’ve been on a winning streak. You enter a trade, and it quickly reaches your predetermined profit target.
However, because you feel confident due to your winning streak, you decide to keep the trade open, hoping the price will continue in your favor and earn you even more profits.
Instead of sticking to your trading plan and closing the trade at your profit target, you let greed take over. Then, the market suddenly reverses, and you end up with a loss instead of a profitable trade.
Allowing emotions to drive trading decisions in both scenarios led to poor outcomes. Whether it’s fear preventing you from taking valid trades, or greed tempting you to aim for unrealistic profits, it’s crucial to keep these emotions in check and stick to your trading plan.
Reviewing Your Trades
Let’s use a practical example to illustrate the value of reviewing your trades using a trading journal.
Suppose you’re a forex trader mainly trading between EUR/USD and GBP/USD. You use both a trend-following strategy and a mean-reversion strategy. After a few weeks of trading, you take some time to review your trading journal.
Here’s what you might find:
- Analysis of Trading Pairs: You observe that you’ve made consistent profits with your EUR/USD trades but experienced more losses with the GBP/USD. This might suggest that your strategies are more effective with the EUR/USD pair under current market conditions. Based on this observation, you might decide to focus more on the EUR/USD until market conditions change.
- Review of Strategies: You notice that your trend-following strategy has been performing well during periods of high volatility, while your mean-reversion strategy is more successful during quieter, ranging markets. This could help you decide which strategy to use based on current market conditions.
- Trade Entry and Exit Points: By reviewing your trades, you might notice that you’ve been consistently entering trades a bit late, missing a portion of potential profits, or exiting trades too early, leaving profits on the table. You can adjust your entry and exit rules based on this.
- Emotional Analysis: You might notice a pattern where losses often follow a string of winning trades. This could suggest that overconfidence after a win might be causing you to take riskier trades, deviate from your trading plan, or neglect your risk management rules.
By regularly reviewing your trading journal, you can identify these patterns and trends you might not have noticed otherwise. You can then use this information to fine-tune your strategies, improve your decision-making process, and become a successful forex trader.
Practice Risk Capital Rule
Only trade with money you can afford to lose, known as “risk capital.” Never trade with the money earmarked for your daily living expenses or savings. This helps keep your financial health intact even in case of losses.
Risk capital refers to the portion of one’s investment funds that one can afford to lose without impacting their lifestyle, meeting daily living expenses, or damaging their plans.
Utilizing only risk capital for trading brings peace of mind, a precious commodity in the high-stakes world of forex trading. So when trading with money you can afford to lose, you’re less likely to make impulsive, emotion-driven decisions.
The psychological comfort that comes from knowing that a loss, while disappointing, will not materially affect your financial well-being allows you to think more clearly and objectively, contributing to better decision-making.
However, it’s crucial to remember that trading with risk capital doesn’t mean one should be reckless.
Even though these are funds one can afford to lose, it’s still essential to apply robust risk management techniques, such as setting stop-loss levels, diversifying trading assets, and not investing more than a certain percentage of the trading account in a single trade.
It’s about managing risk effectively rather than avoiding it altogether.
Use Leverage Wisely
Leverage can maximize your profits, but it can also amplify your losses. That’s why it’s crucial to use leverage wisely in forex trading.
While brokers may offer high leverage levels, you don’t need to use the maximum amount. Lower leverage gives you more room for price fluctuations and reduces the risk of getting a margin call.
The more you understand how forex markets work and what drives price changes, the better positioned you will be to use leverage effectively and responsibly.
Using leverage wisely in forex trading is all about striking the right balance between potential rewards and risks.
Indeed, as a retail trader in the forex market, you must never stop learning and improving.
The market constantly evolves with new trends, strategies, and economic developments, and keeping up with these changes can give you a competitive edge.
Stay informed about current market trends. These trends often dictate the direction of currency pairs. Utilizing charting tools and indicators can aid in identifying these trends, thereby informing your trading decisions.
Also, keep an eye out for new and evolving trading strategies. Online trading forums, webinars, and educational resources can be excellent sources of new ideas. So don’t be afraid to adjust your strategies as you learn and grow as a trader.
Summary- Money Management in Forex
Money management in forex trading involves strategic practices to optimize profitability while minimizing risk.
Some Key elements include:
- Using only risk capital (money you can afford to lose).
- Diversifying your trading portfolio across different currency pairs and strategies.
- Controlling emotions to make rational decisions.
- Wisely using leverage to amplify profits without risking significant losses.
Regularly reviewing trades and learning from past performance is crucial for continual improvement and success in the forex market.
Also, as with every forex practice, money management has to suit you as a trader/ your trading style. The forex market throws all kinds of complexities. Therefore, you must be flexible.