There are many famous quotes about money:
“Money makes the world go round.” – Liza Minnelli
“A fool and his money are soon parted.” – Dr John Bridges
“Rule #1: never lose money. Rule #2: never forget rule number one” – Warren Buffett
Clichéd as they may be, these quotes are genuine and relatable. As FX traders, we are in the business of handling funds. Getting to the point of consistent profits requires a mastery of forex money management.
Most traders are fixated on the end goal of getting rich and neglect the importance of managing. There are ‘commandments’ regarding forex money management that we should respect. Let’s unpack this concept and more (for more tips on successful trading in FX).
What is forex money management?
Money management for forex is a defensive framework used by traders to preserve their capital, reduce risk and ultimately increase their equity. It covers everything from position sizing to a conducive withdrawal plan.
Investors tend to use risk management and money management in trading interchangeably. Although the two are different, everything boils down to protecting your equity.
Each position we place comes with the risk of the unknown. Practising solid forex money management is a massive part of navigating around said risk. No trader has any control over the outcome of their positions. Yet, you do control the maximum you are prepared to lose.
Key considerations for top money management in forex
Here are the main elements to understand regarding forex money management.
This concept isn’t necessarily related to the actual trading of currency pairs. However, it is a good place to start our trading money management analysis since it is sometimes overlooked. One common mistake, made even by experienced traders, is not using disposable funds.
Here, we refer to money separate from your living expenses, savings and tax. Trading with this income means that you have no emotional or psychological attachment to it. This isn’t to say that you should treat these funds as ‘play money.’
Instead, it means you accept the possibility of risk of ruin without linking the capital to your food on the table or rent. Forex money management involves controlling your emotions when real funds are on the line.
The first ‘secret‘ step is to set aside disposable money for your live account.
Conservative per-position allocation
In trading, you never know when your expected winner will come. So, you have to keep spinning the wheel over and over again until it does. However, if you lose the strength to do so, then it’s back to square one.
All professional forex money management strategies ensure that the trader ‘risks small’ for each position. The rule of thumb recommended by experts is 1-3% risk of your account per trade. So, for instance, with $1000, the law says to allocate between $10-$30 for every position.
This percentage allocation is quite conservative, and for a good reason. One simple forex money management mistake by losing traders is betting too much on an individual trade.
The table below details the recovery percentage for each lost portion of your trading capital.
The point is that the higher the individual loss, the more profits are needed to recover it. Conservative allocation is how you can withstand inevitable losing streaks and maintain a healthy drawdown.
We can never be 100% sure of the outcome of any one position. So, it makes no sense to go big. To quote Bruce Kovner, “…whatever you think your position ought to be, cut it at least in half.”
Using a stop loss
Forex is a highly leveraged and sometimes volatile instrument. One minute, the price can go one way, and the next, it can suddenly turn against you. A trader’s primary ‘insurance’ or ‘exit plan’ in forex money management is a stop loss.
The idea of a stop remains a topic of hot debate. But a risk-conscious trader knows it’s a no-brainer in preventing a massive loss or, worse, a margin call. The truth is that no trader can endure a substantial floating loss (unless they were trading with ‘infinite’ funds).
Again, it comes back to emotions. Losing a trade comes with some pain, but the key is getting over it quickly and moving on to new opportunities. A stop loss is a key component of this and the overall process of money management trading.
To quote Bruce Kovner again, “Novice traders trade 5 to 10 times too big. They are taking 50 to 10 percent risk on a trade they should be taking 1 to 2 percent on.”
In simpler terms, position sizing is forex MM 101. It would be crazy to input a random lot size into your trading platform and call it a day. Aside from disregarding stop losses, incorrect position sizing is also a way many traders lose money in FX.
Using a position size calculator only takes a minute to ensure that you keep a consistent allocation for every order. The difference between 0.2 and 0.5 lots is notable. No trader wants the nasty surprise of using the wrong lot size.
Here, we are referring to how you manage your positions once they are in profit. It’s an element which is easy to mess up when you don’t have a plan. Unless your trade has hit the desired profit target, you should trail your stop to a certain point on the chart.
For instance, this could be a Fibonacci level or a particular support/resistance swing. Some traders also use the breakeven stop approach. Regardless, it’s crucial not to close a trade where it shows a substantial profit. Forex trading management involves locking in those gains while allowing enough space for natural price fluctuations.
The final point here is whether you should open additional orders above existing ones. Traders should observe correlations, ensuring they don’t have two opposing positions with the same directional effect.
At this stage of our money management forex discussion, it’s clear that losses are a part of the game. The next step is finding a way where each position is as large as possible to cover the shortfall.
This is where risk-to-reward comes into play, which we express as a ratio. Generally, you’ll always want to make at least twice of what you allocate (1:2). Yet, some traders, like scalpers and day traders, use a lower ratio (e.g., 1:1).
Yet, bear in mind that you need to have far fewer losses (or a higher win rate) to achieve long-term profitability.
Generally, swing traders and position traders have higher ratios because they aim for more pips, given the long hold times. As a result, these individuals can afford more losses (or a lower win rate).
The table below shows the common risk-to-reward ratios along with the required win percentages.
The point is that you should only pursue opportunities with the highest chance of the biggest reward.
At the same time, risk-to-reward in forex money management is only a guide, not an absolute. Risk is constant, while the reward is potential.
The final part of our forex money management conversation is profit withdrawals. Of course, it is the part all traders desire. However, it is often overlooked. What do we mean here? The goal of any trader is to grow their account over time.
Withdrawing, to a certain degree, makes it challenging to trade progressively bigger lot sizes because you have less money. It isn’t to say traders shouldn’t make withdrawals. However, you need a plan where you decide how you will trade larger sizes while having enough margin.
Forex money management myths debunked
Let’s cover a few misconceptions about money management in forex.
Trading profitably without a stop loss is possible
With a stop in place, you can avoid having a big floating loss, which is stressful. Firstly, you cannot position-size without a stop. But, most importantly, it forms the framework for risk-to-reward, which, as we discussed, is perhaps the ‘make or break’ factor in forex money management.
Wide stop losses equal more risk
Here, it boils down to a thorough understanding of position sizing. A larger stop distance doesn’t equal more money allocated on a trade.
Martingale is a good strategy
Martingale, a betting system introduced in the 18th century, is the concept of doubling your position size after each loss. The hope is that at, some point, a single winner will cover all the previous losses.
Theoretically, the system can work. Yet, in practice, it is virtually impossible unless you have unlimited funds.
Having a proven edge in the markets is, of course, vital, whether that is trading with indicators, patterns or something else. But it also boils down to a trader’s ability to count. Forex money management is a numbers game and revolves around protecting what you already have.
Once this objective has been achieved, you can think of growing it steadily over time. You should think of trading forex as mastering three ‘Ms’: mind, method, and money.