Many forex traders start trading live too soon. They don’t have any understanding and learning of good money management rules. As a forex trader, you need to develop a few good money management rules. Practice them on your demo account before starting live trading. By developing your own money management rules you are comfortable with means how much of your money you are willing to risk on one single trade. You also need to determine how many contracts per trade your risk tolerance allows?
The important question is how you can improve your investment results by making small changes to your trading strategies. Proper money management can be the difference between becoming a successful forex trader in the long run or an unsuccessful one who decimates his/her account in a few weeks. Have you ever played poker? If you have, then rarely you will see good players put all their chips on a single bet. As a poker player, you know by risking only a small portion of your money on a single bet, you can win or lose but be still play the next hand. If you put everything on the table on a single bet, you have to be 100% sure of winning. An impossible thing, you can never be 100% right.
Forex trading is far more complicated than playing poker. You are dealing with hundreds of unknown variables that affect the markets instead of only 52 cards. To succeed in forex trading, you must understand and implement the money management principles. You can fall into many pitfalls while trading. As a trader you should be constantly guard against two emotions. Greed and fear! In case you are on a winning streak, you will become greedy. You would want to risk more to make one big win and you would want to strike it rich in one or two big trades. This will make you risk more and more of your money on a single big trade.
When you lose a trade, you become afraid to risk enough of your money on the next trade. Fear takes over and impairs your decision making, making you lose confidence in your judgment and decision making. Le’ts see how fear and greed can play havoc with your trading. Le’ts assume you have a run of successful trades. You become overconfident. You are not satisfied by risking only 2% of your equity on a single trade. You want to risk more on the trade because the more you have in a trade, the more you will make if you are right. You increase your risk to 5%. You win. You increase it further to 10%. You again win. Now, you finally decide to put 25% of your equity at risk on a next trade. Misfortune strikes, your successful run comes to an end. You lose.
Suppose you had a $100,000 trading account and you had foolishly risked 25% or $25,000 on one trade that you desperately wanted to win. Losing $25,000 means you have only $75,000 in your account now after your loss. How much you need to make to get back the original balance of $100,000; you need to make $25,000 again to go back to the original balance. It means you will have to make 25,000/75,000= 33%, so you risked 25% but now you will need to make 33% to get back your original amount.
Many investors once they lose a trade become desperate and try to risk more to recover their original loss. They end up losing more and more and very soon those investors destroy their accounts. Most of them are out of trading forever soon. There are other traders who try to reduce risk even more on making a losing trade; eventually they lose any opportunity for meaningful growth in their accounts. Failure in investing comes in two forms; Failure to maintain your principle and failure to effectively grow your principle. If you want to become a successful trader, than you need to learn how to grow your principle in the long term.
In case you risk too much, you are going to lose a large percentage of your trading account. Now, you will risk more and try to recover the lost amount and in the end you will lose all your account. There is another form of failure that you should beware of. You were able to grow your account 20% every year. Apparently, you may look like a successful investor. But, if you had a good money management plan with you, you could have made 40% or even more in a year. So what do you say was it your success or failure?
You should know before placing each trade how much is really at risk in a single trade? Many traders misunderstand this and dont know what their risk is. Suppose you have a $10,000 account and you buy one lot of EUR/USD contract meaning $100,000. Your forex broker will set aside $1,000 in your account as a margin or guarantee, so how much of your money is at risk? Many would say only $1000 but they are terribly wrong. You have $9,000 left to trade, $1000 was for guarantee. So your risk is $9,000. You can lose up to this much if you are not careful before you receive a margin call from your broker.
A margin call is an order when your forex broker automatically takes you out of the trade once you have lost all but the last $1000. Once you get the margin call, it means you are out of the trade and have lost $9,000 in your trading. How could you lose $9,000 in a single trade? Each pip on a EUR/USD contract is equal to $10. In order to lose $9,000, you need to lose (900*10=9000) 900 pips. Many would say what about the stop loss, dont you need to use it. You are right! You dont need to risk your whole account on a single trade. Never ever trade without a stop loss! You can use stop losses to protect your position as a protection if the trade goes wrong. You could put a 50 pips stop loss losing only $500. You could put a stop loss at 100 pips losing $1000 only.
No matter where you set the stop loss, the amount of money that you set aside with your broker as margin does not tell you anything about the risk unless you plan to get a margin call. Understand these common money management pitfalls. Until and unless, you do not develop your own money management rules, you will most likely slip into one or more of these pitfalls. Investors who enjoy the greatest amount of success in their forex trading are those who have clearly established rules that govern their trading. Those rules are;
1) Live to trade another day,
2) Knowing how much to risk and
3) Knowing how to determine the trade size.
Perhaps the best advice that you will receive from someone is live to trade another day. Currency markets are brutal, volatile and ruthless. In minutes you can lose many pips. You should learn to survive in the markets in the long run. Do not lose all your money in a single day. The most common factor that causes many currency traders and investors to blow up their accounts and lose all their money is greed. Once you start taking unnecessary risks you are in trouble. You want a secret formula that never loses a trade. You will start looking for the Holy Grail technical indictor or a forex robot that can make you rich. You will believe that by discovering one, you will become rich.
Unfortunately there is no Holy Grail in trading. You must learn not to risk more than 2% of your account on a single trade. Incrementally grow your account over time and never ever be tempted to risk big making one single winning trade that can make you rich. You should know how much you are willing to risk in a single trade. I said 2%. But if you want to be aggressive you can go up to 5% but stay between 2-5%. Dont exceed it. If you are conservative, on the other hand, you should consider risking between 1-2% only.
Once you have decided on the risk level you are going to take, knowing the rest is simple for you. Suppose you have a $50,000 account and you decide on a risk level of 2% for a single trade. How much you can risk on a single trade? You can only risk (50,000) (0.02) =$1,000, this is the maximum you should risk on a single trade. However, if you are in more than one trade at the same time, the amount may be higher. Suppose, you are in 3 trades and you risk only $1,000 per trade. So the total amount at risk will be $3,000. Once you have determined your risk level, you are ready to determine the trade size.
Trade size is the number of currency pair contracts you purchase in any one single trade. You need to first determine where you want to put your stop loss in order to determine the trade size. Lets use a simple example to make it clear and suppose you are willing to risk $1000 on trading EUR/USD pair. You decide on a stop loss of 50 pips. Each pip on EUR/USD pair is equal to $10, so the number of contracts that you can trade are 2= (1,000)/ (50) (10). Once you have determined your risk level and calculated the trade size, you have taken the guesswork out of your trading. Now, you can sleep well knowing how much of your amount is at risk and that you are going to be able to trade tomorrow, no matter what happens today. Using these common money management rules will help you avoid the pitfall of losing almost all the money in your account. Learning to survive the markets and trade another day is the essence of trading. This can help your trading take the next level of profitability.
However, if you are a swing trader or a position trader with a longer time frame, your profit potential will be more. If you choose 200 pips as your expected profit then you will need to set your stop loss at 100 pips. The reason that you need to set a higher stop loss on a larger time frame is that small trends occur within the larger trend. Retracements on shorter time frame are much smaller. Retracement on the larger time frame is much bigger. Due to smaller trends in the larger trends, your trade is going to be recycled. In order to be not stopped out of the trade, you need to calculate your risk to reward ratio appropriately.
Consider different risk to reward ratios and how much you need to win to break even. For 2:1 risk to reward ratio, you need 67% winners just to break even. For a 1:1 risk to reward ratio, it means just 50% winners to break even. 1:2 ratio means only 33.5% winners. Never ever trade when the risk to reward ratio is more than 1:2.
Hassam 
