Money Management in Forex Trading (Part I)
Many Forex traders start live trading too soon. They have no understanding and learning of proper money management rules. As a Forex trader, you need to develop some good money management rules. Practice them on your demo account before you start live trading. By developing your own money management rules that you are comfortable with, it means how much of your money you are willing to risk on a single trade. You also need to determine how many contracts per trade your risk tolerance allows?
The important question is how you can improve your investment results by making small changes to your trading strategies. Good money management can be the difference between becoming a successful long-term Forex trader or an unsuccessful trader who decimates their account in a matter of weeks.
Have you ever played poker or watched the game online or on TV? If so, you will never see good poker players play all their cards on a single bet. Good poker players know that by risking only a small portion of their money on a single bet, they can win or lose but still play the next hand. If they put everything on the table on a single bet, they will have to be 100% sure of winning, which is impossible. You can never be 100% sure. Life is the game of probabilities.
You should know that currency trading is much more complicated than playing poker. You will be dealing with hundreds and hundreds of variables that can affect the markets. What to speak of only 52 cards. You must understand and implement good money management rules in order to be successful in Forex trading over the long term.
You can fall into many traps when trading. As a trader, you constantly need to guard against two emotions. Greed and fear! If you’re on a winning streak, you’ll get greedy. You would want to risk more to make a big win and you would want to strike it rich in one or two big trades. This will make you risk your money more and more on a single big trade.
When you lose a trade, you are afraid of risking enough of your money on the next trade. Fear takes over and impairs your decision-making, causing you to lose confidence in your judgment and decision-making. Let’s see how fear and greed can wreak havoc in your trading.
Suppose you have a series of successful trades. You become overconfident. You are not satisfied with risking only 2% of your capital on a single trade. You want to risk more on the trade because the more you have in a trade, the more you will win if you are right. You increase your risk to 5%. You win. You increase it again to 10%. You win again. Now you finally decide to put 25% of your capital at risk on the next trade. Misfortune strikes, your successful run is coming to an end. You lost.
Suppose you have a $100,000 trading account. You foolishly risked 25% or $25,000 on a trade you desperately wanted to win. Losing $25,000 means you only have $75,000 left in your account. How much you need to earn to recover the original balance of $100,000. You must earn $25,000 again to return to the original balance. This means you will need to earn 25,000/75,000 = 33%. So you risked 25% but now you need to earn 33% to recover your original amount.
Once they have lost a trade, many investors become desperate and try to risk more to recoup their initial loss. They end up losing more and more and very quickly these investors destroy their accounts. Most of them will soon be out of business. There are other traders who try to reduce the risk even further by making a losing trade; they end up losing any opportunity for significant growth in their accounts.
