Money management is the backbone of a successful forex trading career - especially if you're trading with limited funds. It's important to manage your money in a way that's good for the long-term health of your account, your long-term finances, as well as increasing your profit potential. Here are some tips on how to practice good money management in forex trading when you're first starting out.
This blog is part of our new Make It Happen series, a series of blogs aimed at total beginners to forex: for people working a full-time job, with little capital to start off with, and limited time to learn how to trade. Sound familiar? Here’s how to get started on your trading journey.
How to Handle Money Management in Forex When You're Just Starting Out
Afraid of losing money you worked so hard to earn at your day job? No idea how to mitigate your risk? Don't panic - we've got you covered. Here are some practical tips on making sure you limit your risk and never lose more than you can afford to.
Set a stop loss
A stop loss is vital to any plan for money management in forex. If you don’t set a limit on your risk, you simply cannot succeed on a long-term basis. A stop loss is key to protecting your funds - it prevents unnecessary losses.
For every strategy, there is a point at which you know that the trade is not going to be successful. Sure, you could get lucky. But successful forex trading is not about being lucky. It is about finding spots in the market where you have a statistical advantage and attempting to profit from this advantage.
Even if a trade reaches the stop loss point suggested by a strategy, the gambler in you will want to hang on and see if you can pull it out. Don’t do that! Even if it does reverse course and turn into a profitable trade, what does that mean for your strategy? If you are going to rely on your “gambling” brain, why follow a strategy at all? Stick with your “rational” brain and stick to the plan for long-term success - make sure you set a stop loss.
Don’t move your stop loss
Another rule that will serve you well is to never move your stop loss. In the heat of battle, it is easy to make rash decisions. Being able to weather this temptation requires you to also set a firm rule on stop losses. Set them when you open your position and don’t ever move them. Always keep a long-term perspective: losing one trade should never be that important. When it is, you are no longer trading—you are gambling.
Want more risk management tips? Read 4 Essential Risk Management Tips...
Calculate your risk per trade
Your risk per trade is typically defined as a percentage of your total capital. Your stop loss and take profit levels should be given by your strategy, or at least roughly estimable. With these figures, you can calculate the number of pips you can expect to gain or the number of pips you might reasonably lose if the trade goes against you.
With that information, it is simply a matter of determining the pip cost of the trade. As an example, assume that your account has $10,000. 2% of $10,000 is $200. This $200 is the maximum amount of capital that you can lose per trade if the risk per trade that you set for yourself is 2% of your account.
This means that each pip would need to have a cost of $200 divided by 25 pips, or the equivalent of $8. By setting up the trade so that each pip is worth $8 and setting your stop loss to trigger at 25 pips, you should lose no more than $8 x 25 pips, or $200. This is a great way to protect your funds and your long-term finances if you're worried about losing too much of your money.
Not sure what pips are? See our easy forex dictionary of trading terms here>>
Set aside a fraction of your income for trading
If you have a full time job, you will build a bigger account quicker if you deposit some - but not all - of your income into your trading account. To do this, you could set aside a fraction of your monthly income - say, 5% of your monthly salary - to set aside for your trading that month. That way, you won't risk more than you can realistically afford to. This also might mean cutting back on other expenses (say, your daily coffees on the way to work) and funnelling that money into your account instead.
This will give you more buying power as time goes on, and enable you to increase your profits by taking on more risk. Even if you go full-time and your forex trading account is the sole source of your income, you will want to set aside a portion of it to remain in your account so that you can continue to increase your ability to weather more risk and gain more reward.
Trading around a full-time job? Here's how to find forex trading strategies to suit your day job>>
Trading too much is a common way of taking on too much risk. Especially if you are transitioning from part-time to full-time trading, trading in a different timeframe than you normally would, or using a new strategy. It is easy to become disoriented when the landscape changes. You can avoid this by setting a firm limit on how much of your capital is at risk. Only risking 2% of your account on each trade, or group or correlated trades, can help you avoid this.
Reward-to-risk ratios should be considered as well when opening a trade. Any trading strategy you use should help you identify a potential take-profit point and a stop loss point. Does the gain from the potential take-profit outweigh the potential loss by a factor of 3 or more? Then the trade is worthwhile. But if the take-profit would offer you 15 pips and the stop loss would lose you 10 pips, that is only a factor of 1.5. It is best to stick with trades that offer a reward-to-risk ratio of 3:1 or more. And if you choose to open positions with a reward-to-risk ratio of 2:1, consider using a smaller position size to control risk.