Successful traders have three key qualities. First, they have an excellent technical knowledge of the financial market. Second, they have a high level of discipline, and finally, they have quality money management skills. We have seen many good traders who lack one of these qualities fail. In this article, we will look at the best method to manage your money in forex.
As you are aware, forex trading is a risky business. It is an industry where you can make a lot of money within a short period of time. It is also an industry where you can see your money disappear within seconds. Therefore, risk management is very important because it helps you make and lose money comfortably. There are several risk management tips that you should always have.
Leverage is the extra amount of money that your broker gives you so that you can maximize your returns. If you have an account with $1000 and you use a 100:1 leverage, it means that you can trade as if you have $100,000 in your account. When things go well, this leverage can help you make more money. However, if a trade goes against you, you can lose more money than what you had deposited in your account.
Therefore, selecting the right leverage is very important to you. Indeed, in the MIFID II regulations that went into effect in 2018, leverage for EU traders was slashed to a maximum of 30. This is because the European Securities Market Authority (ESMA) viewed it as the most common reason why people lose money.
How much to risk
Another good risk management strategy you should have is calculating your risk reward ratio (RRR) before you start trading. An RRR is used to measure the likely reward for a trade compared with the likely loss. For example, if you have an account with $1,000, you may want to risk at most 2% of the funds in a single trade. This means that you should set a stop-loss at a location where the maximum loss is $20. This two-percent is known as the 2% rule.
For beginner traders, it is recommended that you use a very small risk-reward ratio. While this ratio will not make you a lot of money, it will help you to reduce the risk of losing money. With such a ratio, even if you open ten losing trades, it will not have a major impact on your trading account. If you have a $1,000 account and you open five losing trades, you will still have $900 in your account to trade with. If on the other hand you are risking 10% per trade and you lose 5 times, it means that your account will shrink to about 60% of what you started with. You would then need to gain 66% to get back where you started. This is near impossible for an expert trader let alone a beginner.
As you advance in the day trading journey, you can increase the risk ratio.
This is the same principle that is used by professional traders in Wall Street. These managers have strict risk-reward guidelines that they must pass. Failure to which, many of them lose their jobs or are demoted.
Reinvesting Your Profits
Traders use different approaches to this. There are those who withdraw all of their profits and trade only with their principal amount. There are others who believe in reinvesting their profits. Each of these approaches has its benefits and its flaws.
The benefit of reinvesting is that it helps you to have a bigger account. With a bigger account, you are able to open bigger trades compared to when you have a smaller account. However, it also exposes you to the risk of losing your money, especially when you have not put in quality risk management strategies. In the past, we have seen many successful traders lose money this way.
Ideally, we recommend a situation where you reinvest your funds and at the same time, ensure that all of your trades are protected. You protect your trades using stop losses and take profits.
Stop loss and Take Profits
A stop loss is a tool that is found in most trading platforms like MT4 and MT5. The stop loss is put at a place where you are comfortable making a loss. Again, if you have a $1,000 account and your risk-reward ratio is 2%, then you should have a stop loss where you will make a maximum loss of $20. This type of stop loss is known as a fixed stop loss.
A better type of stop loss you might want to use is the trailing stop loss. This is a stop loss that moves with your trades. As such, even with a reversal, your profits are protected. This is the type of stop loss that many successful Wall Street traders use.
A take profit is the exact opposite of a stop loss. A take profit automatically stops a trade when a present profit level is reached. In most cases, traders lose money because they allow their profit-making trades to turn negative. To prevent such a situation, having a take-profit is very essential.
Having these money management strategies is not enough. Indeed, many traders with excellent strategies don’t succeed. This is simply because, these strategies need to be reinforced with discipline. In other words, discipline is the bond that ties all these strategies together.
For example, it is common for traders to close their trades before their profit targets are reached. It is also common for traders to extend the stop loss in a loss-making trade. By so doing, they expect that the chart will reverse and possibly become profitable.
Similarly, there are traders who exit their profit-making trades before the target price is reached. They do this out of fear that the trend will reverse. The risk of doing this is that the traders often make a smaller profit than they would have made if they waited for the trade to continue to the end.
Another common example is when traders add more money to their losing trades. They do this by opening another similar trade. They do this hoping that the trade will recover and make a bigger profit. In most cases, this does not work.