Many have said that it is not necessarily the trading strategy that you employ but the psychological aspects of trading forex which will determine a traders’ success. Whilst this is certainly true in terms of being disciplined to stick to the rules of a trading system, there is also another essential element to becoming a profitable forex trader. This can be described as money management and the ability to protect trading capital and to ensure that a trading account moves in the right direction over the long term.
Three golden rules of money management in forex trading
Money management includes two or three golden rules which, if maintained, will substantially increase the possibility of becoming a consistently profitable trader regardless of the trading system used. Although it is useful to have a perfect trading strategy, the truth is that all traders will experience losses and losing trades regardless of how good their trading system may appear. It is how these losses, and expose to loss, is controlled which will determine if a trading account is still in operation a few months later. Since many traders may find it difficult to admit loss, it is essential to automate rules to deal with losses as much as possible.
The first way to limit losses is to physically limit the risk on each and every trade. This should ideally not be any more than 2% of the total trading capital available within an account. Despite this seeming like a very small amount to be risking on each trade, the reason why professional traders follow this rule is to allow them to absorb consecutive losses should they occur. For small forex accounts, it is tempting to risk anything between 20-50% on each position but this can easily deplete an account if a trading strategy fails to perform for more than one trade.
A second measure of good money management is the risk-to-reward ratio that is applied to each trade. Ideally, trading with a risk-to-reward ratio of 1:2 will allow a strategy to lose a number of times but still remain profitable over time. This means that the amount of money being risked, or the potential losses, are lower than the potential gain from a successful trade. With a strong ratio, the number of winners will not need to be higher than losers for long term profits to be realized.
Stop losses as tools to reduce trading losses
Finally, given the difficulties that almost all traders initially have in accepting losses, it is important to ensure that bad trades are closed as quickly as possible. One of the most effective ways to do this is to employ an automated stop-loss which is placed in the market when a forex trade is placed. Stop-losses act a safety nets against large market moves and limit the loss on any losing trade to a pre-determined amount. Although stop losses do not guarantee to close a position at the precise price in fast moving markets, they will avoid the temptation to “wait and see” if a trade will come back in the favour of the original trade. This not only prevents runaway losses but if stop-losses are placed strategically, they will only be triggered once a trade has failed.
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