The importance of money management in Forex
When a person starts trading Forex, they enter the market with a goal to be successful and generate payouts. But there will be times of failure and losses for even the most successful traders because that is the nature of the market: it’s a zero-sum game where in order for some to win, others must lose.
There are lots of different methods traders can use to control the number of losses and increase their chances of payouts. This is possible via money management in trading. Money management is a set of guides and techniques that are designed to help people better budget and distribute their financial assets.
By using proper money management techniques, it is possible to limit the number, as well as the size, of losses and make your trades more profitable. As many successful traders point out, without employing money management, trading becomes more like gambling where it’s about chance and luck and not meticulous planning to get better results.
In this guide, we will discuss the top five money management tips for Forex traders that help them make most out of their trades:
- Risk only as much as you can afford to lose
- Use leverage with caution
- Use stop-loss to limit losses
- Use take-profit to protect payouts
- Trade less correlated currency pairs
Forex trading money management strategies
Risk only as much as you can afford to lose
As we noted earlier in the article, people start trading in order to get payouts. But some people have this mindset that by trading Forex, they will get super-rich in a very short amount of time.
Admittedly, this can happen to a tiny group of people, but this is more because of the chance and not of a particular strategy. Usually, however, when traders open too large positions in hopes of big outcomes, they end up losing their whole account in several trades, which indicates that the risk they are taking is too much for the account.
Just like any other financial market, Forex is very unpredictable and traders should have a mindset that they can lose their money at any point. Therefore, a good strategy for money management, Forex traders can use is open trades with just enough funds that they can afford to lose. This way, they will avoid risking excess portions of their account and maintain funds for the upcoming trades.
As a rule of thumb, risking only 2% of your whole account is a good way to manage funds. For instance, if you have a $100,000 account, you should open new trades with no more than $2,000 each.
Use leverage with caution
Leverage is a very popular feature in almost every trading market. It is especially rampant in Forex, with brokers offering higher leverage ratios to their clients.
As we already know, traders can use leverage to increase their trading capital by a certain multiplication rate. For instance, a 1:200 leverage ratio can allow a trader to open a $100,000 position for just $500. This way, they can get the same payout sizes with smaller deposits.
However, the leverage also makes you more exposed to market failure and increases losses with the same amount. For example, if you lost $1 in a $500 trade, you’d lose $200 if you had opened a leveraged position for $100,000.
Therefore, a proper Forex money management strategy would be to use only as much leverage as you absolutely need and refrain from expanding the position too much. As a result, your exposure to market risks will be limited and not too destructive for your account.
Using stop-loss to limit losses
Obviously, your hopes when placing a new trade are that the market will go in your favor and bring you payouts. However, the chances of opposite market movements are also very high, which is why you need to make sure you’re prepared for it.
Virtually every trading platform popular in the industry is equipped with lots of risk management tools. One such tool is a stop-loss. The stop-loss protects trades from unexpected market fluctuations and consecutive losses.
When a trader places a stop-loss limit, they determine a maximum price change - and the size of a loss - they’re willing to endure. And if the price continues to change beyond that point, a trade will simply stop, protecting a trader from damaging losses.
Therefore, it’s always best to use a stop-loss limit as one of Forex money management strategies. Yet it is also important to note that it’s not about merely using it; a trader has to carefully determine the limit beyond which they’ll stop trading. Here, the above-mentioned rule of 2% can also be useful: setting a stop-loss at a level where you lose no more than 2% of your trading balance in a single trade.
Using take-profit to protect payouts
A take-profit is a similar tool to a stop-loss: it helps traders determine a certain price point beyond which a trade will stop. However, it has the opposite purpose: traders use it to mark the minimum amount of payout they want to get from the trade.
It is understandable that every trader wants to maintain the trade open for a bit longer to get extra payouts, however, the longer the position remains open, the higher the chances are to lose even the generated payouts. That’s where the take-profit limit comes in. It marks the minimum price change that is beneficial to, as well as enough for the trader and as soon as the market reaches that point, the trade will stop immediately.
Both stop-loss and take-profit money management techniques in Forex trading require proper expectations from the trade. It is easy to want to get a small fortune from the trade and place stop-loss/take-profit orders according to your desires. However, by actually determining the risks and rewards of each trade and having realistic expectations, the chances of success become greater with fewer losses.
Trade less correlated currency pairs
This final tip for money management for Forex traders is about using assets that aren’t correlated to one another. This is actually a similar strategy to what traders on other markets use to diversify their portfolios.
The currency correlation is a value of the relationship between two currencies. The value ranges from -1.0 to +1.0. If the currency correlation is -1.0, it means that two currency pairs are always moving in opposite directions, whereas the +1.0 correlation implies the pairs move in the same direction.
There’s also a third important point in this measure: if the correlation reads 0, the two Forex pairs have no observable correlation and their movements are totally random. As an optimal money management Forex trading strategy, it can be a good idea to trade those pairs that have no correlation to one another. This way, if one market development affects a certain pair, your whole portfolio will likely have better chances of survival - similar to what portfolio diversification does in stocks and other markets.