Money Management In Forex Trading
Money management in trading refers to a particular set of rules that help you to maximize your profits minimize potential losses and expand your trading profile. More often than not it’s those new to forex trading who tend to neglect basic money management rules and end up blowing their accounts as a result.
In this lesson we will discuss topics like developing a trading strategy risk management lot sizing and risk to reward ratio. You will also learn about various trading styles and the risk associated with them. Lets start with developing a trading strategy.
Developing a Trading Strategy
Developing a trading strategy is the most important part it defines your future in trading. If you have a better trading strategy you will have better chances of making a living from trading. However always remember that no strategy is perfect and even a successful strategy requires changes with time. That is why you will also have to continuously assess and improve your strategy.
There are many factors in developing a trading strategy largely it depends on how you see the market how much you are planning to invest what your needs are and what you expect from trading. Your investment size will depend on your financial strength but it is always advised to test the waters with a small investment and then gradually increase it. Once you determine these things then you need to pay attention to other factors like the trading style and trading approach you want to adopt.
You can be a day trader a medium-term trader or a long term trader. Day traders usually track and analyze the market for an entire day and prefer to close their positions before the end of the day. Medium-term traders plan their trades in a way that their positions can remain open for several weeks. In contrast long-term traders follow a bigger trend and their positions can remain open for months until their targets are achieved.
If you have a day job probably day trading will not suit you but if you wanted to be a full-time trader day trading is very much for you. It is also possible to spread your positions across different time frames for example you can plan to have one or several medium to long term trades and during the same period you can seek short term opportunities and perform day trading as well.
Risk management is one of the most important parts of a trading strategy. You can choose between aggressive conservative and moderate approaches. In an aggressive approach traders enter the market with large quantities. The aggressive trading style carries huge risks and is only suitable for experienced traders.
The moderate trading approach carries less risk compared to an aggressive trading approach. The new trader should only start with a conservative approach as it provides the necessary space to identify and fix the flaws in your trading strategy.
So your trading approach will determine the risk factor for instance you will risk more if you adopt an aggressive approach and you will risk less if you adopt a conservative approach. Always remember when you are new to trading you should adopt a conservative approach.
Trading style is an important part of your strategy it determines how you read the price action and make your decisions. There are various trading styles for example you can be a swing trader. A swing trader generally prefers to enter and exit the market when there is high volatility. You can also learn to trade the breakouts a breakout trader carefully examines certain price levels and places the trades only when those levels are breached. Likewise you can also trade the reversals japanese candlesticks patterns and western charting patterns are an excellent way to spot and trade the reversal. Scalping is another popular trading style that is very popular among forex traders. In this trading style traders analyze the market and place the traders for very short periods typically between 5 and 30 minutes.
Risk To Reward Ration
The risk to reward ratio is a crucial component of your risk management strategy. Basically it defines the amount that you will earn for risking every dollar. For example if you are trading with a risk to reward ratio of 1 is to 3 it means you will be risking $1 for a potential profit of $3. Likewise if you are trading with a risk to reward ratio of 1 is to 1 you will be risking $1 for a potential profit of $1.
To figure out the risk to reward ratio you should use let’s assume that you placed 10 trades with a risk to reward ratio of 1 is to 2 meaning you will risk $1 for every $2 profit. Now let’s assume you won 5 trades and also lost 5 trades. So in terms of numbers you lost $5 and made $10 which means your net profit is $5. Similarly if you were trading with a 1 to 1 ratio you will lose $5 and win $5 meaning that you will be at break even.
Now it’s easier for you to understand what risk to reward ratio you should be trading with. A 1:1 ratio lower risk to reward ratio will not leave you enough space to play around while a 1 is to 2 ratio will keep you in profit even if you lose 50% of your trades.
Remember! If we do not get a second confirmation from the double RSI, the Chandelier Indicator signal will not be confirmed, and we will not take the trade.
Lot sizing is also a crucial part of risk management. It defines the quantity you will trade. Trading with a bigger lot size means higher profit but it ultimately raises the risk. Likewise trading with a small lot size means low profits but low risk. Trading with small lots also means that your investment will not yield high profits. Therefore it is important to trade with a reasonable lot size that does not carry high risk and also make sufficient profit at the same time.
So what is a reasonable lot size? If you trade with a mini lot a 100 pips movement will not be as big as trading with a standard lot. Let’s say your account balance is $1000 and you trade with a standard lot. A 100 pips movement against you will completely wipe your account. If you make the same trade with a mini lot a 100 pips movement will only give you a loss of $100 and if you trade with a mini lot it would give you a loss of only $10.
So the lot size defines your risk. As a general rule of thumb you should not risk more than 5% of your total capital in a single trade. Therefore the ideal way to choose a lot size is by adjusting it to 5%. In our example of $1000 equity your maximum risk on a single trade will be $50 therefore a safe trade would demand trading with a micro lot. Remember that you can always trade multiple micro mini or standard lots.