The oldest and most important advice to all forex traders is to learn how to limit risk and manage money within a trading account. This is fundamentally the most important element to master in order to achieve consistent success and profitability as a trader but is also one of the most neglected aspects of trading for newcomers. Many of the most successful forex traders will identify the ability to manage both risk and money as the single most important factor in their success, and many others will also argue that this is far more important that the strategy employed. Of course, forex traders need to maintain a solid trading strategy but the ability to maintain a healthy account balance takes ultimate discipline and commitment.
Why managing risk is essential in forex trading
Managing risk is essential in forex trading for two reasons. The first of these is that it needs to be employed in order to be consistent with the potential profits that can be achieved and, secondly, risk management will allow a trader to continue trading even during periods of poor performance. Using risk management strategies such as the absolute requirement for stop-losses on each trade is a popular way to limit downside exposure during trades that fail to perform as anticipated. The placement of these stop-losses should be relative to the expected gains, and ideally with a risk-to-reward ratio of no greater than 1:1. Managing risk relative to expected gains is an effective way to ensure that the risk taken on each trade is no greater than the potential profit. This should allow a trading strategy with an ‘edge’ to outperform the market if discipline is maintained and stop-losses are never extended beyond their pre-determined level.
A common problem with risk management
Risk management involves a large degree of discipline and preventing the temptation to move stops or ‘average down’ a position. One of the most destructive practices is to try to reduce the losses incurred on a failing trade by exposing an account to even further losses, or to become dogmatic and continue buying or selling in to the trade in order to lower the average purchase price. The acceptance that trades cannot always be profitable is essential to exercising effective risk management. Limiting the damage during these negative trades is more important for the health of an account than the profits of the winning trades.
The golden 2% rule
Experienced forex traders maintain that the managing money as with any business is paramount to achieve trading success. They point out that a single forex trade should never exceed more than 2% of available capital in an account. For new traders this can seem unreasonable, given that the start-up capital in trading is likely to be low and the availability of gearing forex trades with just a small amount of capital is an omnipresent temptation. The reality is that by limiting each trade to just 2% risk a trader is far less likely to blow their account than risking 15-20% which is a more common figure. Clearly, the number of consistently losing trades required to deplete an account is far more when just 2% is at risk. Furthermore, with a risk:reward ratio of at least 1:1, a 2% growth rate on each trade is a very reasonable return. The awareness also that, as the account grows the value of 2% will also become greater; compounding profits and producing faster growth over time.
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