Introduction to Money Management in Forex Trading
All the below is part of Forex money management: a series of rules, tricks, and techniques to minimize risk and maximize profits in your portfolio that separates the sophisticated investors from the average ones.
The ability to manage every one of your trades to make the best of your trading portfolio as a whole is priceless. It acquires the skill to fix or reduce a losing trade so it won’t damage you and maximize the profits on winning trades.
Later on in this article, we will learn how to apply money management to your specific trading styles, so keep reading!
The basics of forex money management trading
First, some basics:
Calculating your lot size
As you know, in forex trading, we trade in lots. We have the option to trade mini lots and micro-lots as well. So you must understand how to calculate your lot size for every trade, so you don’t risk more than you should.
A full lot equals 100,000 U.S. Dollars of currency traded. A mini lot represents 10,000 U.S. Dollars and a micro lot 1,000 U.S. Dollars. In order to measure a pip value, you divide them by 10,000.
Example: 1 lot (100,000) / 10,000 = 10 U.S. Dollar per pip.
To keep things simple, a full lot (1.00 Lot) will represent about 10 U.S. Dollars for every pip of movement in price. A mini lot (0.10 Lot) will represent about 1 U.S. Dollar for every pip variation in price, and a micro lot (0.01 Lot) will represent a 10 cents gain or loss for every pip of movement.
So if you are trading 5 mini lots and the market moves in your favor 10 pips, you would gain 50 US Dollars.
Where should you place your stop loss
Depending on your strategy, your stop loss may be placed at a fixed amount of pips far from your entry price or placed differently on every trade depends on the setup.
If you are trading a strategy with a fixed stop loss, this will always be at the same distance from your entry point. But if your strategy dictates you place your stop loss according to a specific setup, it is important to understand where to place the stop loss. In this case, remember that price will move almost freely between support and resistance levels, so you will want to place your stop-loss order at the opposite side of these levels and avoid getting stopped out before the trade develops in your favor. See the image below for an example:
The 1.5% rule
To keep your losses small, you want to avoid risking more than 1.5% of your capital on any single trade. Remember that losing trades are sometimes unavoidable, so you want to make sure you can recover from every single loss relatively quickly.
Now you know where you will place your stop loss BEFORE entering a trade, and you know how to calculate lot size, so make sure you don’t risk more than 1.5% on a single trade.
For example, let’s suppose you are trading on a $10,000 account.
Your maximum risk per trade should be 150 US Dollars (1.5%).
You find a setup, and your stop loss will be placed 20 pips from your entry point.
If you divide $150 between 20 pips, you will find that every pip needs to be worth 7.5 US Dollars.
This means your lot size for this specific trade shouldn’t be more than 7.5 mini lots (0.75 on your platform).
Win / Loss Ratio
The first statistic you need to know is how accurate your strategy is. Meaning that for every 100 trades you take, how many of those trades are winners, and how many are losing trades? That is the win/loss ratio.
Have a look at your past 100 trades and figure this out. Ideally, your strategy wins more than 50% of the time.
An average good strategy usually wins about 70% of the time.
Risk / Reward Ratio
Equally important, or even more, is the risk/reward ratio. Meaning how much money you win on a winning trade and how much you lose on a losing trade.
Think about it. It is worthless to win 90% of the time if you only produce 1 dollar for every winning trade but lose 50 dollars on losing trade.
Out of your last 100 trades, sum the profits from the winning trades and divide it by the number of winning trades. Do the same for your losses. How does it look?
So again, ideally, you want to get into trades with the potential of gaining double the amount of money you are risking. Anything above that is even better.
Finding a balance between the two ratios is crucial. And a good mix of both will do wonders for your account.
With the basics in place, let’s move on into a money management key point: evaluating a trade before taking it.
Before even entering a forex trade
Correct money management starts before you even enter a trade. It starts with evaluating a trade before you take it, making sure it’s a worthy trade. Think of trades as limited opportunities. Every non-worthy trade requires you to commit money into it, money that you won’t be able to commit to better trade.
So let’s learn how to evaluate a trade.
What is your set up?
The rules on your strategy will tell you what patterns to look at and what requirements need to be met to be a valid setup. Remember that a valid setup considers all the filters defined on your trading strategy and makes sure that specific trade meets the risk-reward ratio parameters.
Where would you go out?
By this question, I mean where will you go out both if the trade fails or succeeds? You need to be able to define where your stop loss will be placed before taking the trade. That way, you can measure the amount of pips you risk and define your lot size.
Knowing the amount of pips you are risking allows you to calculate where your initial take profit will be placed. Ask yourself if that point is a realistic and achievable level; If price needs to break through major and historic resistance or support levels to achieve a 2:1 reward/risk potential, chances are it won’t hit it soon.
Is this a trade worth taking?
Put all the pieces together. Before entering a trade, make sure you are trading a valid setup that aligns with your strategy rules, calculate your risk and be realistic about the chances of the trade getting to its take profit and gaining at least two times the risk you took. Hope shouldn’t be part of the equation.
If it’s a trade worth taking, you have to pull the trigger. How? Let’s find out some ways to enter a trade.
How to enter a trade
By how to enter a trade, I don’t mean what type of entry order to use. Placing a stop order, limit order, or market order should be defined by your strategy.
In this section, we will discuss position techniques to enter a trade.
Basically, you can trade like a sniper or like a shotgun machine.
Sniper trading
Trading like a sniper means allocating all your per-trade capital on a single high probability entry point, the whole 1.5% at once. All in.
The advantage of this trading style is that it maximizes your profit when the trade succeeds.
The disadvantage is that you leave no available capital for fixing the trade if it goes wrong or entering at a better price if the opportunity presents itself. It is a very rigid way to enter a trade.
This way of size allocation will work just fine on strategies that have proven to have a high risk/reward ratio, and you need to be very disciplined, so you let your winning trades reach their targets.
Shotgun trading
Trading like a shotgun machine means breaking your capital into small positions, entering the trade with little pieces at different entry points by multiple confirmation signals.
Let’s say you want to enter a trade with 1 lot. Instead of allocating the full lot at once, you split it into five 2 mini lot positions and slowly enter the trade as you get different valid entry points. You could get these entry points in a smaller time frame, for example.
The advantage of this style is that it allows you to enter the trade at different and ideally better entry points.
The disadvantage comes when the trade goes in your favor at the very beginning because you only entered at the first point with a relatively small position.
So which way to enter a trade is better? It depends on the trader and the winning percentage of the strategy. Practice both, and very soon, you will understand which one suits you better.
My trade is going against me, What should I do?
Part of money management is handling losing trades and, on some occasions, fixing them. Think about it: you already know your strategy produces about 60% profit trades, meaning you lose 40% of the time. If you could fix half of the losing trades, now your system loses only 20% of the time. Don’t forget that not every trade is fixable, and in some cases, taking the loss is the best way to exit a trade since you are not risking more than you should anymore.
So how do we fix fixable trades?
Scale-up for a losing position (averaging a loss)
Remember that one of the advantages of a shotgun trading style is leaving some capital for entering a trade at better prices. And you can use that extra capital for fixing trades.
Scaling up on a losing position means entering a losing trade in the same direction with the same amount or a bigger amount of money than the initial trade.
For example, you enter a 0.1 buy trade, and it moves 10 pips against you, so you enter another 0.1 buy trade. Once the second trade moves 5 pips in your favor, you could exit the whole position for breakeven. One trade lost 5 pips, and the other one profited 5 pips.
You mustn’t exceed 1.5% of your account if all the fixing attempts trades fail.
Scale down for a losing position
This fixing technique works well on trades where you allocated the maximum capital available and reduces your risk ratio.
Scaling down means reducing your position once you understand the trade will most probably fail.
Let’s say you enter a 0.2 trade with a 100 pip stop loss, taking a total risk of 200 dollars. The trade already moved against you 60 pips, and everything shows the price will reach your stop loss. In that case, you could choose to close half your position for a 60 pip loss (banking a 60 dollar loss) and let the remaining half either turn back and move in your favor or simply reach the stop loss. If the remaining open position reaches your stop loss, you will lose an extra 100 dollars, totaling a 160 dollar loss instead of a 200 dollar loss initially risked.
Hedge
Hedging means opening the opposing position to current open trade. Simply trading the same currency pair in both directions at the same time.
There are many variables as to why and when to hedge correctly.
If you trade the same lot size in both directions, you will profit in one direction while losing in the other one, so basically, you freeze your trade to reevaluate what to do with it. You buy time.
You can also increase your lot size when you hedge a trade, so the losing position loses a little while the winner one wins a lot to compensate for the loss.
As an example, you enter a 0.1 buy order. At some point, you realize the trade could move sharply against you, so you place a 0.3 sell stop order (pending order). If the price continues to drop, eventually, the sell order will profit more than the buy order losses.
The cons for hedging is that sometimes you will get triggered on both sides without important movement to compensate for the loss. Again, you should not exceed 1.5% of your account on failed hedges.
How to manage an open position in forex
Once you are in a profitable position, there are certain decisions you can take to make the most of the trade, from maximizing profits to eliminating risk. Let’s explain some trade management techniques:
Turn your open position into a risk-free trade.
For doing so, you can practice scaling out, trailing your stop loss, or a mix of both.
Scaling out means closing part of your position when it is in profit and leaving the rest of it running.
The pros of doing so are to make sure you will not lose money at all, even if the remaining position hits your stop loss since you have already booked some profit.
The cons of doing so are cutting your winning trades and not taking advantage of the big winners, reducing your reward ratio.
Trailing stop stands for adjusting your stop-loss order in the direction of your winning trade, either to a breakeven point or a pivot closer to price. Again, by doing this, you ensure you will not lose money, but you need to make sure you allow the market enough room for normal fluctuations. Otherwise, you will be taken out of the trade just before making a big movement in your favor.
Maximize profits
Scale in a winning position. If you recognize a trade will continue running in your favor, it may be a trade worth adding to. Identify important points or pullbacks as opportunities to increase your position and maximize profits.
Compounding strategy
Compounding is a very powerful way for investing and asset allocation.
In short, compounding means reinvesting your profits. Instead of investing a fixed amount of money per trade and withdrawing profits, you invest those profits again in consecutive trades.
That way, your growth becomes exponential.
Compounding is a very wide topic and has a lot of benefits. Click here to learn more about Compounding a Forex Account.
Mental targets and time stops
Everybody talks about price targets and stops, but almost no one explains time stops and mental targets.
Mental targets are realistic targets based on market structure. All strategies are written on paper, and many times they don´t take into consideration market conditions. It is very easy to say, “place your profit target at 2x ATR”, but if that target is placed above a historical high, most probably it won’t be reached. So mental targets align your profit target to what is achievable and not ignore important support and resistance levels.
Time stops are orders placed according to time averages or cycles. A time cycle is how long, on average, it takes for the market to move from one point to another.
Let’s suppose you know the market usually moves 100 pips in 7 candlesticks, and you have a 100 pip target the market has not reached yet in over 11 bars. In this case, it is taking the market more time to cover a 100 pip distance, so it is slowing down, and you may consider taking your profits.
The art of taking profits
Taking profits is one of the most difficult things to do correctly. Taking profits too late may cause a position to turn over on you and become a loss. Taking profits too early will make you leave potential money on the table. So taking profits is more an art than a science.
Let’s explore some options for taking profits:
Let your winnings run
You might have heard this before, cut your losses short, and leave the winnings run. Especially if you are trading on trending markets, a trend may continue running for a long time. You want to make sure you take advantage of a running market.
Use some techniques from the last chapter to avoid losing money, like trailing stops or scaling out, but make sure you leave some capital on and running.
Once you have reached profits five times the risk you initially took, any time is a good time to take profits. Making a 5:1 risk-reward trade is exceptional.
Hold on expansions, profit on consolidations.
Markets move from consolidations to expansions.
Consolidations are good areas to place some orders anticipating the next expansion and are also good areas to take profits from an open position profiting from the last expansion.
Be realistic
Back to time and price cycles. If you know the average time cycle for the specific traded market and reached your target points before the average time, you are in a good position, and you should let it run!
Don’t forget to align your strategy rules to the reality of the market. Either it is support and resistance, supply and demand, Elliot waves, or time cycles, don’t expect from the market more than it can give you, but take them as much as you can.
Tuning money management to your strategy and forex trading style
Money management applies to every trading style and every strategy.
Strategies styles
Let’s explain some of what we have learned for different types of strategies.
Some strategies are based on trading a fixed position size, so they rely on a bigger win/loss ratio and risk/reward ratio. If that is the case, make sure your stop loss is well placed every time, so you keep the losses small.
Some strategies use a fixed percentage or pip risk and a flexible take profit so that every losing trade will lose the same percentage or pip amount every time. If that is yours, make sure you take trades with a profit potential of at least two times the risk taken.
Others use a fixed risk and a fixed profit target that, in theory, is set at more than 2 times the risk taken, BUT as you have learned already, the profit target needs to be placed in a realistic place given the market context. Avoid taking trades with small, realistic profit potential.
Trading styles
That being said, let’s compare how to apply money management to different trading styles, such as scalping, swing trading, or long-term trading.
Scalpers usually try to take advantage of every small market movement, taking small profits every time. The risk/reward ratio for scalpers tends to be low, but they compensate for this with a very high win/loss ratio.
Scalpers may try to split their entries in small positions (shotgun trading), entering every time at a better price, and manage their losses with averaging, scaling up on losses.
They can also consider letting some of the winning trades run longer for bigger profits.
Swing traders ignore small pivots and focus on more important price points, and hold their trades longer. Swing traders have a lot of freedom in managing their trades.
There are no better or worse techniques for swing traders, and they can opt to mix between trade management styles depending on their own profile. As always, keeping high win/loss and risk/reward ratios will do wonders for their trading.
Long term traders (position traders) will focus only on the most important price levels and tend to trade on longer time frames holding their trades for days.
Position traders may prefer a sniper type of entry. Otherwise, it might take days for the price to come back to a new entry-level. Scaling down on losses and surely trying to scale up on winning trades to squeeze the whole large trend and compound it.
Forex money management conclusion
Money Management is one of the most important and wide topics when it comes to successful forex trading.
A famous quote says, “a bad trader will lose money with a perfect strategy, and a good trader will make money with a bad strategy.” This stands true because of the right implementation of money management. You simply can’t make consistent profits with poor money management skills.
Make sure you tune money management to your method so you:
- Dominate the basics
- Evaluate a trade before entering
- Enter in the right way at the best possible price
- Manage loses
- Maximize profits
Practice and master correct money management, and you will soon find yourself among the best forex traders out there.
