Forex and Money Management
Too many traders focus on a winning strategy but forget about the factor that makes or breaks most traders. Forex and money management seem to some as disconnected as Buffet is to Bitcoin. Traders may have good intentions but the greed of the moment overtakes many and wreaks havoc on most accounts. Only a controlled patient process wins the forex game in most cases.
If you want to win at forex you have to first consider yourself to be a risk manager as opposed to a risk taker. You are trying to conserve your money at all times. Money management plays a significant role in this regarding two critical factors: the amount you risk per trade and the risk-reward ratio for each trade.
The Key to Winning in Trading
The instrument is forex and money management is the key. Is it this simple? Indeed, money management is one of the most important if not the most critical factors in successful trading. If you're risking too much on any one trade, sooner or later you'll pay the price. Money management has at least a double effect. It keeps you in the game longer and risks very little compared to the average gain.
It's not enough to have an excellent winning average if your drawdown is too significant to recover from. You could have a 70% winning average but a substantial drawdown due to poor money management. You'd spend a long time trying to recover to break even and be tempted to risk even more to recover quickly. As a result, you'd increase the odds of even a more substantial drawdown. You don't want to increase your risk; you want to maximize your reward per trade
Limit Your Risk
There are different ways of limiting your risk, but the best method uses a fixed percentage of your account per trade. Although many traders use a percentage risk as high as 1-3%, I lower the risk on my technical trades to 1%. This lowering may lead to a smaller profit but also a more modest drawdown. Again, we want a smaller drawdown despite the trade-off with lower earnings because it keeps us in the game longer.
You want to be around long enough to take advantage of the trades that average a more substantial reward. A lower risk also lowers anxiety and the chance of emotional reactions when trades go wrong. Slow and steady wins the race and allows for a more rational response to avoid overtrading or FOMO.
Risk to Reward Ratio
The risk to reward ratio is a big part of forex and money management. We aim for a 1:3 risk to reward in on our technical entry trades as our trades will stand a good chance of hitting that target due to the strong sentiment behind it. Our trade entries are based on a retracement of a trend. A trend that not only can be seen technically but fundamentally as well. It must be a strong sentiment, one based on news that can move the price to the intended target.
This means our risk is only made with trades that are part of a strong trend that wil probably continue for some time. It's a risk that's worth it because it's small and backed by a high probability trade. Being overly selective about your trades is another way of lowering risks and thinking of yourself as a risk manager as opposed to a profiteer.
You're in the market to make a profit, but the irony is that the more you focus on creating a profit, the less you make. The more you focus on any way you can reasonably reduce your risk, the more you make in the long run.
Increasing Your Risk to Reward Ratio
I stick with a set risk to reward in general. However, you can adjust your target further to create a more significant risk to reward ratio. This adjustment should only be made if one is confident that the underlying news is of such importance that it can sustain a prolonged run in the direction of the trend. Examples of this include :
- surprise rate hike or lack thereof,
- excellent or abysmal unemployment report,
- surprise geopolitical events.
Such changes should be infrequent, and the minimum risk to reward should be 1:3. You need to understand the reasons for your trade. As you can see, my decisions are never purely technical. These include fundamental news as a primary decision maker to enter a trade in the first place. Therefore, I use the fundamentals throughout the trading process, including the resetting of targets, if needed. The advantage of having a fixed target is that your more likely on average to attain a risk reward of 1:3 unless you know your stuff. Again, judging whether a trade has more room to move implies knowledge and lots of experience of how the news affects price movement.
Can I Create a Lower Risk in Some Circumstances?
There are ways to lower your risk even further. Moving your stop loss as the trade moves in your favour is a well known technique. However, this should not be used aggressively, as a trade needs room to breathe.
We can add a time factor to this as well so that the stop loss is only moved after several hours, days or weeks depending on the type of trade.
The fundamentals will have a part to play as well. If you know that the news has changed slightly since the trade was first entered, then it may be time to move the stop loss closer to break even.
On the technical side, the closer the price is to round numbers or a critical support/resistance, the more likelihood of a bounce, This is another reason for moving the stop closer to break even.
Indicators can help show when a trade is overbought or oversold. This list includes RSI, Money Flow Index, Stochastics. It's a confluence of these technical instruments that will be the best indicator that a reversal point many have been reached.
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