Forex Money Management

09/11/2014 9:00 am EST

Focus: FOREX

Forex traders focus so much attention on entry and exit strategies but often forget about finding a good money management strategy as well, so Adam Lemon of DailyForex.com emphasizes the importance of money management and outlines what the three main strategies are all about.

Traders tend to focus so much on trade entry strategies, thinking that this is the key to success. In fact, not only are trade entries less important than trade exits, both are less crucial to success than good money management. Unfortunately, money management strategy tends to be overlooked. It is vital that your money management strategy is a good one, otherwise successful trading will be very hard to achieve. Fortunately, it is not a very difficult area to master.

Money management just means how much money you risk on a particular trade. Even if you are making trades without having predefined stop losses, you will still be risking a certain amount per pip, which is where your money management strategy is applied. So your money management strategy is how you decide how much to risk on a particular trade.

Why Money Management Strategies Are Important

The main reasons why money management strategies are so important are:

  1. If you keep risking the same amount on every trade, and do not adjust for your losses, you might eventually either lose all of your money, or lose so much of it that it becomes very hard to recover (more about this in the table below).
  2. It is important to have a system that determines how much you risk on each trade to keep things proportionate, otherwise you can lose too much on the losers and not enough on the winners to benefit from successful trade entries and exits.

A common mistake is to forget that when you lose money, you have to make more (proportionately) to get back to where you started than you lost.

This can be hard to understand, so here is an example:

You start with $100. You lose $20. You have lost 20% of your money.

You now have $80. To get back to where you started, you need to make a profit of $20. But wait! $20 is not 20% of $80, it is 25%. So you need to make more than you lost.

The table below illustrates how much you have to make, proportionately, to make up losses.

chart
Click to Enlarge

NEXT PAGE: The Three Main Money Management Strategies

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Forex Money Management Strategies

There are three main money management strategies. Let’s review each of them.

Risking a Fixed Amount per Pip/Trade

This is a very simple strategy, but it is extremely flawed for the reasons that we already outlined.

Risking a Fixed Proportion of Equity per Pip/Trade

This is a better strategy. It has two major advantages:

  1. Winning streaks result in exponential multiplication of winnings, whereas during losing streaks, you lose less and less on each trade.
  2. You can never completely wipe out your account.

This strategy can be made even stronger in two ways.

First of all, you do not have to size your risk the same on every trade. For example, you might have “A” grade trades that you feel really confident about, then “B” grade trades that you want to take but feel less confident about. You could risk more on the “A” grade trades. This can be a useful psychological tool to help you overcome any fear of losing trades that you are suffering, but it should be used carefully.

Secondly, you can adjust risk for volatility, by using the Average True Range indicator (ATR). For example, you might decide that you will risk 1% of your equity for 3 times the average true range of the last 20 days. This will ensure that your winnings and losses should not fluctuate too dramatically as market volatility changes. This has the effect of smoothing out your equity curve, which is important, because it will improve the overall compounding effect on your account. This compounding effect is a major factor in long-term profitability and is often overlooked.

Forex Money Management Spreadsheet

You can keep track of your money management most easily by keeping a spreadsheet of your trades, showing your total equity after each trade. Using formulas can show you quickly how much you should be risking on your next trade.

Forex Martingale Money Management Strategy

This article would not be complete without a quick explanation of the Martingale Strategy. Very simply, this strategy tells you to keep doubling your risk after every loss, until you eventually make back all your losses. There are variations of the strategy where you risk even more than double your previous risk.

This strategy should be avoided at all costs, as it is the easiest and surest way to completely wipe out your account. If you start by risking 1% of your account, you will wipe out your account as soon as you encounter a losing streak of seven consecutive losing trades. You will certainly have a losing streak of seven consecutive trades. It is certain to happen. The Martingale Money Management Strategy is only guaranteed to work for someone who has all the money in the world. If you had all the money in the world, why would you be trading?

By Adam Lemon, Contributor, DailyForex.com

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