Forex Money Management.

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Money management is a way Forex traders control their money flow: literally IN or OUT of
own pockets... Yes, it's simply the knowledge and skills on managing own Forex account.

Forex brokers will rarely teach traders good money management skills, though almost all
brokers will offer some sort of education, therefore it's important to also learn on your own.

There are several rules of good money management:

1. Risk only small percentage of a total account
Why is it so important?
The main idea of the whole trading process is to survive!
Survival is the first task, after which comes making the money.

One should clearly understand that good traders are, first of all, skillful survivors. Those
who also have deep pockets can additionally sustain larger losses and continue trading
under unfavourable conditions, because they are financially able to. For an ordinary trader,
the skills of surviving become a vital "must know" requirement to keep own Forex trading
accounts "alive" and be able to make profits on top.

Let's take a look at the example that shows a difference between risking a small
percentage of capital and risking a larger one. In the worst case scenario with ten losing
trades in a row the trading account will suffer this much:

Risking 2%
Trades Account balance
of total account per trade
1 Start — 5000 100
2 4900 98
3 4802 96
4 4706 94
 5 4612 92
6 4520 90
7 4430 89
8 4341 87
9 4254 85
10 4169 — 17% of the account has been lost

Risking 10%
Trades Account balance
of a total account per trade
1 Start — 5000 500
2 4500 450
3 4050 405
4 3645 364
5 3281 328
6 2953 295
7 2658 265
8 2392 239
9 2153 215
10 1938 — over 60% of the account has been lost

Apparently, there is a big difference between risking 2% and 10% of the account balance
per trade. A trader who has made 10 trades risking only 2%, under the worst conditions
would lose only 17% of his initial investment. The same trader who had been exposing
10% of the balance per trade would end up losing over 60% of his initial investment. As
you can see, this simple decision — a money management approach — can have serious
consequences if misjudged.

2. Returning the lost capital is harder that it seems to

Let's take a look at calculations where a trader has lost some part of his account. How
much effort will it take to recover the original account balance?

Account % of account lost New balance Need to make

$ 5000 25% $ 3750 35% of the new balance ($ 1250) to cover losses
$ 5000 50% $ 2500 100% of the new balance ($ 2500) to cover losses
$ 5000 75% $ 1250 300% of the new balance ($ 3750) to cover losses
Now, here is a challenge: try on your demo account to gain a return of 300% or at least
100% of your original account trading as it were the real money. Will that be easy? I don't
think so. Can you prove me wrong?

3. Calculate risk / reward ratio before entering a trade

When chances to win in a trade are smaller than potential losses, don't trade! Remember
— staying aside is a position.

For example:
losing 40 pips versus winning 30 pips,
losing 20 pips versus winning 20 pips,
both examples are showing a bad risk management

Before entering a trade, reassure that risk / reward ratio is at least 1:2 (but ideally 1:3 or
higher), which means that chances to lose are tree times less than promises to win. For
example: 30 pips of a possible loss versus 100 pips of a potential win is a good trade to
consider taking.

Adopting this money management rule as a must, in the long run it will dramatically
increase your chances to succeed in making stable profits.

Next chart shows the risk / reward rule in practice.

10 trades with 1:3 risk / reward ratio were conducted.

A trader was losing only $100 in a trade when he was wrong, but was winning $300 in
each profitable trade.

Trades Losing trades Winning trades

1 +300
2 -100
3 -100
4 +300
5 +300
6 -100
7 +300
8 +300
9 -100
10 -100
Total - $500 + $1500
Grand Total + $1000 in profit
As we can see, using 1:3 risk / reward ratio constantly and being successful only 50% of
the time, anyone can make a profit in the end. The higher the reward ratio (compared to
the risk ratio) the better are chances to end up in profit.

4. Learn to use protective stops

Still unsure whether you need it?

Every day hundreds of Forex traders blame themselves for being so naive and trading
without protective stops. Hundreds of others lose funds worth weeks, months & even years
of trading just only in one very unsuccessful trade.

And yet another hundreds of traders, having heard dozens of times about importance of
protective stops, open new trades ignoring the well known money management rules.

Stop loss isn't often a favourite tool for many Forex traders as it requires taking necessary
losses, calculate risks and foresee price reversals. However, a Stop loss tool in hands of a
knowledgeable trader becomes rather a powerful trading weapon than a cause of
disappointment and painful losses.

Every trader is free to develop his / her own trading style and implement own money
management rules. We will go over several methods of using Stop losses.

1. Simple equity Stop

It's an important money management rule: not to risk more than 2-3% of the total account
per trade. According to this rule, a trader would place an order and based on a lot size
would calculate amount of pips required to reach the limit of 2-3% of the total account
balance (and a stop loss will be placed at that point).

For example: a trader has $1000 USD account, he places a buy order of 4000 units on
EUR/USD, which will give him on average $0.40 cents per 1 pip. Since 2% risk that he is
willing take equals $20 USD ($1000 * 2%),
calculations will be next: $20 / $0.40 cents = 50 pips is the limit for this trade.

2. Chart based Stop

Used by many traders, this stop relies on different chart patterns, indicators and signals
received when analysing the market. There are many styles & techniques associated with
different Forex trading systems .

There are several approaches to placing protective stops:

- stops based on swings high / low,
- stops using trend lines,
- Fibonacci related stops, etc.

Let's take a look at some examples below:

A stop loss based on the last swing low (double-bottom pattern)

A stop loss based on Fibonacci projection
A stop loss using a trend line
5. A practical example of applying money management rules:
Risking no more than 2-3% of the total account per trade... How does it work in practice?
Let's use an example to understand it.

We have opened a trading account of $1000 USD with a broker and got 20:1 leverage. So,
now we have leveraged ourselves to $20 000 USD to begin trading with.

More money means a higher trading power. Correct. But, the higher the trading power, the
higher the risks; and when we talk about risks we talk about a real account value which will
decrease with every loss sustained during trading. So, when we say risking no more than
2-3% of a total account value we mean the real account value — which is $1000 USD in
our case.

Now, let's start trading and do the math.

Let's say, we have decided to risk 2% of the account in each trade.
$1000 x 2% = $20 USD.
This means that when the price goes against us, we will need to be out of the trade once
we are $20 dollars down.

Ok, time to trade. Our trading power measures $20 000 USD (thanks to our leverage).

What will happen if we try to trade them all at once: for one $20 000 dollar trading lot order
our Forex broker gives us a pip value of $2 dollars. This means that with each pip gained
we will have +$2 USD in our pocket. But this also means that with each pip lost
our real account will shrink by $2 dollars.
Since we can afford to lose only $20 dollars in one trade, we'll exiting a trade once the
market makes... -10 pips! Yes, only 10 pips is required this time to reach our 2% limit.
10 pips * $2 USD per 1 pip = $20 dollars, which is our 2% account limit according with the
money management rule we've chosen to follow.

Now, let's try to trade a $10 000 dollar position. The pip value for this position size will be
$1 USD.
The math goes as follows:
we can stay in trade until market makes -20 pips against us. Yes, this time we can sustain
a bigger market shift.

If we decrease our trading lot to $5000 USD, our sustainability will raise to -40 pips against
our trade. (The pip value for $5000 dollar lot will be $0.50 cents).
And so on.

As you can see, with the money management rule in place our real account is under
control. And even if leverage allows trading larger positions, the risks should be always
under control.

Good trades!