Just as the Ten Commandments form the foundation of Christians, in trading forex, there are also particular money management ‘commandments’ that should be unbroken. Regardless of whether one day trades or opts to swing trade, some money management principles remain constant, which this article will cover in detail.
Thou shalt always know the dollar amount to risk per trade
Perhaps the first money management ‘commandment’ is defining the exact dollar (or currency equivalent) amount one risks on a trade-by-basis. Although much of the existing trading literature currently cites the fixed percentage rule, the actual monetary value is more important.
So, while a trader can decide to risk 1% of their equity for every trade, they should internalize the real amount, whether that is $10 or $100. It is being comfortable with that value that makes it easier for one to align themselves with the expectation of possibly losing money in one or even several consecutive positions.
Just as a business expense is expressed in a specific monetary value, a trader should take the same approach in line with their overall trading account. Although there is some benefit to focusing on the percentage or pips lost, knowing the real value applies the necessary emotions to appreciate the risk involved.
Maintaining a consistent risk
As a sub-component to this principle, traders also need to maintain a consistent risk and only increase it after pre-defined points using other advanced money management techniques. There is no point risking $50 on one position and then $150 on the following one.
Despite how probable the success of any trade may appear to the eye, the actual probability remains 50%. Maintaining consistent risk throughout allows a trader not to place any unnecessary significance over one position since the outcome will always be binary.
Thou shalt always use a stop loss
Unsurprisingly, using a stop loss in forex is what separates the professionals from the amateurs. Although the idea has always been controversial in many trading communities, the truth is as forex is a highly leveraged market, protecting one’s downside is paramount.
We should also consider that most are trading with a finite amount of money. Even risking a small 2% of an account can mean enduring large negative gains without using a stop loss (or even a margin call).
A risk-centric trader fully understands no one knows how far a market can go against them and that losing is a painful part of the game, no matter the level of technical skill. Using a stop loss ensures we define our invalidation points or the points at which, according to our strategy, our analysis was wrong.
The process of losing should be as quick as possible, which then frees up time for traders to move on and focus on other opportunities with enough ‘bankroll.’
Not moving a stop and ‘break-even’ trades
Furthermore, traders should never move a stop when it’s in place unless to reduce the risk after a predefined period or to ‘break-even.’
Regarding the latter, breakeven stops (moving a stop loss to the point of entry) aren’t for everyone, and it takes a harnessed discretionary ability to know when to utilize them.
The purpose is clear: many times, there will be positions that technically neither lose nor make money. However, a common mistake is moving a stop too soon, which doesn’t allow enough ‘room’ for the price to move as it fluctuates heavily.
In some cases, such as when a trader has been in a position for, let’s say, two days, and the market isn’t moving much, they may consider using a breakeven stop as they’ve allowed ample time.
Thou shalt always calculate thine position before every trade
The importance of calculating the position for every order ties in perfectly with the previous two ‘commandments.’ We will only know the monetary risk and stop loss by using a position size calculator.
Traders shouldn’t attempt this part by manual calculation because of the mathematical specifics in lot sizes. Before opening any order, using this calculator is vital as this is how one knows the exact stop loss distance in line with the dollar amount at risk.
Thou shalt always know thine risk to reward ratio
Because losing money is inevitable, the risk to reward ratio is the only mechanism that increases the chances of profiting long-term. The risk to reward ratios are an integral function of money management but are not without their flaws.
A great deal of discretion is applicable with this system since there is no universal approach. However, each trader should have a general framework or guide to what they aim to pocket off each position, but they should also appreciate not every trade will net the desired profit.
As a rule of thumb, intraday traders tend to have the smaller risk to reward ratios (such as 1:2 or even 1:1) as they typically hold positions for shorter periods. On the other hand, a swing or position trader, because of holding their orders for much longer in the pursuit of ‘bigger moves,’ will naturally have higher ratios (at least 1:5 or much higher).
Having a robust money management plan involves many different moving parts that all need to function simultaneously like a well-oiled machine. A losing trader may be using stops and know the real dollar amount they’re risking but might close their positions too soon by either not allowing enough time or taking profits early.
Another trade may get everything right, but by not always using a stop loss for every trade, it is always a matter of time before their account is at risk of a margin call. Consistency is what truly matters with money management, which is what these ‘commandments’ should train one to be going forward.