Trading is often referred to as speculation. Successful speculation is an art, as many times a strategy that works on paper, fails when live trading.
The secret ingredient to successful trading is money management. While the term sounds fancy, it refers mostly to the ability to plan a trading strategy and to execute it.
Money Management in Forex Trading
Every trade has an entry, a stop-loss order, and an exit strategy. Together, they are the core of the money management system that makes the difference between winning and losing.
Traders coming to the FX market with the intention of winning every trade will be disappointed. With trading, the aim isn’t to win every time. Instead, the idea is to win more than losing. And, the winners to be bigger in size than losing trades.
When researching and building a trading strategy, the starting point shouldn’t be how much profit to make, but how to protect the trading account. There’s a reason for that: most retail traders fail on their first attempt at trading currencies.
Statistics tell that almost ninety-percent of retail traders fail on their first deposit. That’s a terrible percentage and explains much about the need to protect the trading account first, and only after that to focus on growing it.
The risk of a trade considers two things:
- where to place the stop-loss order
- how much to invest in every trade
The easiest way to combine the two is to use a percentage from the equity of a trading account for the trade size. And, to adjust the actual volume to the distance needed for the stop-loss.
For instance, if a trade needs fifty pips as stop-loss, and the trader risks one percent of the equity on each trade, the solution is to set the volume in such a way that if the stop-loss is reached, the trader loses only one percent of the trading account.
A proper money management strategy needs a decent risk-reward ratio. Being bigger than two is mandatory. It means that the possible reward must exceed two times the risk.
Professional traders include the adjacent trading costs in this calculations. They account for commissions, spreads, swaps, taxes, and other fees before calculating the 1:2 risk-reward ratio.
The bigger the ratio, the better for the money management system and for the trading account.
Dealing with a trade is an emotional rollercoaster. However, if traders follow a strict money management plan, chances to survive on the long run increase exponentially. Moreover, the emotional component won’t affect them anymore, and, as a result, they start enjoy trading the currency market.