Without proper money management, you are sure to lose…lose everything. Even a trader equipped with the best trading system in the world will be left penniless if he
is careless about money management. I have been cautioning all my clients to concentrate on money and risk management for trading success in forex.
I would like to put my money management system in simple terms to make every reader understand my way of managing money.
There are 5 basic constituents of a money management plan:
The first decision a trader makes
is to choose the currency pair he trades. How is it important? If we take Eur/GBP,
it moves very slowly and there is a possibility of our margin getting tied up for
a longer period of time. On the other hand, if we take forex exotics like USD/ZAR or USD/SEK, the intraday movement is too much for a small retail trader to even think of money management. The longer you are in a trade the more risk you take on due to the possibility of political uncertainty, news announcements, etc. This also thwarts your ability to enter additional trades because it ties up your margin. It is always a better decision to trade forex majors like Eur/Usd or GBP/Usd where you can come in & come out swiftly.
2. Size of the trade
Deciding the size of the trade is an important money management decision which is often overlooked. It is always better to diversify, in fx trading, to minimize the risk factor. One needs to make multiple trades, to increase the opportunity to win, by catching successful trades. The purpose of money management is to control the risk by not overextending your margin and putting yourself in a position to have a margin call. This concept is the single most important aspect of trading in regard to rules. Most of the beginner traders and even some of the seasoned traders greatly increase their chances of failure by overextending themselves and using poor money management before moving the odds in their favour.
We should follow certain rules while choosing the lot size.
Risk per trade
The overall risk is the amount of money you are willing to risk in total between all the open positions. For example, let’s say you are using 10 percent as your overall risk limit and you have $1000 as the available margin. In this case, you would never want to lose more than 100$ in your portfolio. If you trade 0.01 lot (worth 0.10$ per pip), then your exposure would be 100/0.10=1000 pips. Then the combined pip count of all the stop loss cannot be more than 1000 pips.
Risk per trade is the amount you are willing to risk for a single open position. In my rich trading experience, it should not exceed 2% on one trade. If we take the above example, we may not stretch the trade beyond 200 pips in a single trade. Stoploss placement will
not only decide your optimum point of stop loss but also decide the lot size. Suppose you plan to place the stop loss at the support level which is located 45 pips below your entry and you plan to set it 5 pips below the support level, you may then risk a maximum of 4 such lots in the above-given example (50 X 4=200).
Stoploss is of much importance in forex trading. As a trader, you should learn to accept losses gracefully, but if losing the capital will lead you no where.
3. Entry of the trade:
Before we enter the trade, we should have a thorough understanding of the process of
calculating the maximum allowable risk per trade. Let’s assume that you have multiple trades open and you receive a sell signal on the Eur/Usd. You have $805 available margin after allowing for the stops that are in place on the existing trades; assuming a 2% percent risk allowance, that would allow you $5 to trade with. If the nearest resistance was more than 50 pips away, it is not pragmatic to open this trade (worth 0.10$ per pip ). Therefore plan your entry which will be close to a support or resistance
4. Limit Level
It is always important to visualize your target without which there is no way to compare the risk to reward. For example, for a profit target of 18 pips, it is not wise to risk 30 or 40 pips. Always remember in forex, or any other market, that the possible profit is at least equal to the accepted risk. When trading a system that has proven to be profitable, proper money management will ensure that you can weather the losses and stay around when the trade goes your way. After all, if you have a system that is 70 percent accurate and you lose the first thirty trades out of one hundred you better have enough margin left to trade for the next seventy.
5. Hedging: Why would a trader hedge?
Many traders think in many ways, but I have a firm belief-Hegding has only one purpose and that is to limit risk. The fear of being stopped out can be eliminated by using proper hedging techniques. If a hedge entry is properly managed the worst possible turn out is a minor loss. The problem with hedging is that it requires a lot of patience to resolve the hedge. A hedge order is a trade placed in opposite direction of an existing trade of the same currency pair. U.S forex rules do not allow hedging and so do the majority of the brokers; therefore, you must first verify with your broker that they do hedge; otherwise,
an attempt at a hedge order will cancel both trades. A hedge order is a great alternative to a stop and should be used for the same purpose: limit risk, not making a profit. Regardless of your trading experience, realize that losses are inevitable and therefore you must manage them. When your stop is hit, you are done, no second chances. However, a hedge position allows for some flexibility and maybe even some profit. The initial order is your primary focus for profit, the hedge order protects the account from blowing off when the market does something unexpected. Another advantage of hedging is the ability to increase or decrease position sizing on the hedged position.
For example, your first entry is long on the EUR. With two lots, your second position is entered short with one lot or even four lots. I only suggest entering with more lots if you have strong indicators telling you that the market is going to continue against your first entry. When managing a hedge, treat it as a standalone trade. Take caution when closing a hedge trade and your primary entry is in the negative. You should immediately place a second hedge order at your regular stop distance to protect the primary trade. Many people have a problem grasping the concept of hedging, so be assured that this is not a complicated method. Simply manage it as if it was a standalone trade and this will simplify things significantly.
If you are trading with a broker who does not allow hedging, you may still use this strategy. However, it requires two separate accounts. All hedge orders will incur the standard broker fees and margin requirements in place. The first thing to do before hedging is open a demo account and practice, practice, practice. As with any new concept in trading, you must experiment with it until you are confident in your ability to manage a trade that has been hedged. Secondly, always place your hedge orders at the place you would regularly place your stop. The objective is not to trigger your hedge order only to protect your primary entry. The worst case scenario is the hedge position is brought in and the currency reverses again. At this point you have two options. The first is to ignore the pair completely (both the initial order and the hedge) and compensate the negative with a later trade. The second option is to place an additional trade in line with the primary entry with multiple lots. This should only be done if you are trading with the overall trend and you have a valid reason to enter the trade. This trade must be hedged as well; you would place the hedge order at the proper stop level just as if this were a new trade.
Managing your risk management is the most important factor to consider in your trading. It should guide all your other decisions, including how much to trade, where to place stops, and your strategy once you enter. Use my suggestions, protect your capital and make successful trades.