Beginners Guide to FX Trading - Module 5
Module 5: Money Management and Controlling Risk
Developing a sound plan for money management and understanding how to control risk are two of the most important skills for all traders to cultivate. There are many ways to do this with techniques ranging from the relatively simple through to extremely complex. At their heart, all of these methods require you to consider issues such as:
- How will you keep your risk to a minimum?
- How will you keep total account value at a maximum and grow it?
- What money management techniques will I use?
- What sort of leverage do I want to use?
Keeping Your Risk to a Minimum
You don’t need to “hit a home run” with every trade. Although the substantial leverage available to you in the forex market greatly magnifies the amount of funds you can control per trade, you are not required to utilise the full amount on every trade. Many successful traders only risk a small fraction of their overall account balance on any one trade. Whether you use a fixed dollar amount, a percentage of your account balance, or a pre-determined number of pips, it is a good idea to know from the outset how much risk you are willing to take with each trade. The next important step is to stick to your pre-determined risk figure and not allow your emotions to take hold. Fear and greed can cause traders to deviate from otherwise robust trading plans.
The majority of trading platforms will allow you to place stop-loss orders to minimise downside risks and take profit orders that allow you to lock in profits. It is a good idea to learn how these features work on your platform.
Whenever you are trading foreign exchange, it should never be done with money that you cannot afford to lose.
This is a fun one to explore. What are your goals for your account, and what will you do with it? Remember, this is the riskiest of all the financial markets. If you are profitable in your account, some feel it is beneficial to protect it by removing some of it from the market. Some weeks you may make your goal and some weeks you won’t, don’t stress out if you miss a week or two. Just build that into your plan. Aiming for 100% success rate is just setting yourself up for failure.
As outlined above, you will need to undertake some research to determine which model of money management you wish to adopt. There are many to choose from. You can find details online or in one of the dozens of books dedicated to the topic.
One of the simplest methods of money management that is popular with retail traders is often referred to as the “2% rule”. Followers of this rule aim to risk no more than 2% of their overall account balance on any single trade. If you think that is low risk, consider this – Many institutional traders measure risk per trade in figures of considerably less than 1% of their overall AUM (assets under management).
As you begin to adopt rules for buying and selling make sure you maintain a close eye on the ratio between open trades and your total account value. It is easy to start over-leveraging your account as you make trades. Over-leveraging means you are using more of your available margin to hold open positions. The danger with this is that if the price moves against your trades you may find you have insufficient funds to meet the margin and maintain your open positions. This is definitely something to be avoided.
Leverage, as mentioned above, can be a very useful tool for many traders, but it is important to remember that it is a double edged sword. Leverage increases the value of funds that you can control with the funds in your account. While it increases your profits on good trades, it will also increase your losses when a trade goes against you.*
Review and Renew
Your trading plan should be a work in progress that is never really complete. It should be reviewed periodically and fine tuned as the performance of your trading develops.
As you are considering these issues for yourself, make sure you learn as much as possible. There are forums, discussion groups, websites and an entire software industry that has grown up around trading strategies. Don’t be afraid to ask questions and explore options. This should be an enjoyable process, not a hard or scary one.
* The leveraged nature of FX trading means that any market movement will have an equally proportional effect on your deposited funds. The possibility exists that you could sustain a total loss of initial margin funds and be required to deposit additional funds to maintain your position.
Forex trading is one of the riskiest forms of investment available in the financial markets and suitable for sophisticated individuals and institutions. The possibility exists that you could sustain a substantial loss of funds and therefore you should not invest money that you cannot afford to lose.
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