What is more important in Trading especially in Forex Trading? Technical Analysis or Risk & Money Management? Most people would answer Technical Analysis, most people love Technical Analysis, but the bitter truth is Money Management is more important than Technical Analysis in Forex Trading. Developing a good Money Management system is the key to success in Forex Trading. With an average Technical Analysis still, some profit can be made but with bad Risk & Money Management habits all the money could be lost and you can blow your account. Money Management is a technique to manage the money in a Forex Trading account to minimize your losses as minimum as possible. It is not possible to make all trades in profits, losses are part of the game. Money Management techniques are used to keep the losses manageable so that another chance to new trade can be availed.
We win by Not Losing
A lot of new traders try to make a profit from every trade which is not possible in reality. The more focus is on winning and make profits but nobody work on the losses. The main aim of the Money Management system in Forex Trading is to minimize the losses as much as possible. Forex Trading is a business and who take Forex Trading a serious business is the one who makes money. Below are some of the main rules of Risk & Money Management in Forex Trading. If these rules are followed mechanically, the chances of successful trades with good profit increase exceptionally.
2% Risk Management Rule
When you are entering any kind of trade, you are taking some risk. Forex Trading is a Financial Market where the risk of making a profit or loss is very fast and as soon as you enter a trade the profit or loss becomes clear. So how much are you willing to lose on a single trade? This is the first question you should ask yourself before you enter any trade. Professional Traders with a lot of experience in Forex trading advise not to take risk of more than 2% on any trade. For Example with a $ 1,000 account, a Forex Trader should not risk more than $ 20 per trade that is 2%. By making the rule of 2% you are risking a very small percentage of your account.
Maximum Trading Account Loss
It is very important to set a maximum limit of loss of your Forex Trading Account where you will stop trading or close some of your trades and rework your Forex Trading Strategy. A big mistake done by new Forex Traders is that of not setting a maximum loss limit or maximum Forex Trading Account drawdown limit resulting in blowing of their Forex Trading Account. It should be very clear to new Forex Traders that their Forex Trading Account can wash out to zero if there is no proper risk & money management applied. Before applying any Forex Trading Strategy on Real Forex Trading Account it is important to backtest the strategy first, check what is the maximum overall loss you have made during the backtesting if the maximum overall drawdown of your account is 5% with any particular Forex Trading Strategy you can set your Maximum Forex Trading Account limit of 5% on your real Forex Trading Account. Professional Forex Traders recommend keeping the Maximum Forex Account Loss limit between 7% to 10%. It is important to note that the more loss you make on your overall Forex Trading Account it becomes more difficult to recover the loss to break even. The below table shows simple mathematics of how you have to make 100% profit to reach breakeven if you make a 50% loss on your Forex Trading Account. For Example, if you have $ 1,000 in your Forex Trading Account, by making a couple of wrong trades and bad money management you have incurred a loss of 50%. Now there is only $ 500 left in your Forex Trading Account. To convert this capital of $ 500 again to $ 1,000 you have to double your money that is you have to make 100% profit.
Amount Loss in Tradiing Account(%) Amount to Recover for Break Even (%)
Risk to Reward Ratio
Risk to Reward Ratio is a term used by Traders to calculate how much amount of capital a trader risks to make to make a certain profit in any trade. Professional Forex Traders and Forex Coaches recommend a Risk to Reward Ratio of 1:2. A Trade entered with a Risk to Reward ratio of 1:2 suggests that a trader is risking $ 1 to make a profit of $ 2. With the Risk to Reward ratio of 1:2, a Forex Trader needs to win one trade out of three to be on breakeven. As a trader increases the risk to reward ratio, for example, 1:5 or 1:7 it means the trader needs less or few trades to be on breakeven and a trader can now make more trades with the same capital. Below is the table which gives you insight into how a proper risk to reward ratio can be helpful in Forex Trading.
Risk to Reward Ratio Winning Trades for Break-Even
1:1 50% (5 win out of 10)
1:2 33.3% (3.33 win out of 10)
1:5 17% (1.7 win out of 10)
A stop-loss is one of the most useful tools that can be used by the new Forex Traders. A stop loss is placed by the Trader to automatically buy or sell any security when it reaches a certain point. A stop-loss act as a tool to cut or limit the loss at a certain value. For Example, you bought a GBP / USD Forex Currency Pair at 1.3834 and placed the stop loss at 1.3800. As soon as the price of the Forex Currency Pair GBP / USD reaches 1.3800 it would be automatically sold even if the trader is not login to the trading account. The Forex Trader would incur a loss of 34 pips only and we the price reaches 1.2589 the trader would be out of the trade at 1.3800 saving the trading account from further loss. There are no extra charges for placing a stop loss but it has a big benefit on your trading. A stop-loss makes decision-making very clear for the Forex Trader and helps to remove the emotions from the trading. For Example, if a Currency Pair is coming down the Forex Trader would immediately sell the Currency Pair but the same Currency Pair can pull back from the price the Forex Trader has sold. If a logical and well-calculated stop loss is placed it would help the Forex Trader to not make an emotional decision in a hurry.
Using a Trailing stop loss
Trailing stop loss is a kind of stop-loss that is used when your security is going in profit. The trailing stop loss is placed below the current price when your trade is going in profit. For Example, you bought Forex Currency Pair GBP / USD at 1.3834 and it starts to move up slowly. When the Forex Currency Pair reaches 1.4596 you place a trailing stop loss at 1.4500. So if the price of the Currency Pair reaches 1.4500 it would be automatically sold and this time you would be in profit as you bought the currency pair at 1.3834. The Trailing Stoploss can be adjusted as your currency pair makes a new high. The advantage of the Trailing Stoploss is that the profitable trade keeps on running unless the stop loss is hit and if the price makes a new high the trailing stop loss can be adjusted further up. Moreover, if the trailing stop loss is hit the Forex Trader doesn’t make a loss instead the Forex Trade is closed with a profit.