Top 5 Forex Money Management rules

Top-5 Forex MM tips

Money management is one of the most important aspects of trading but is often either misunderstood or is largely ignored. While traders tend to spend a lot of time searching or improving their trading strategies, not much of thought is given to the money management aspect of trading. But this is understandable as by and large there are many different principles surrounding money management which often ends up confusing the reader. Read these top 5 forex money management tips to help make it easier for you trade manage your money while trading forex.

1. The 1% Rule

Starting with the most obvious, the 1% rule in money management states that you should expose or risk more than 1% of your equity to a position. For example, if you are trading with $10,000, then with the 1% rule, you should allocate not more than $100 of risk to a trade. While this looks straight forward, it is a bit more complex than that. For example, if you were trading with a mini lot size of 0.10 and your risked amount is $100, this means that your stops are placed around 100 pips from your entry. If you scale down your lot size to 0.01 or micro lot, then your stops can be placed 1000 pips from your entry. But if you trade with 1 lot, then your stop loss has to be no more than 10 pips

From the above, we can see how we have arrived at different risk levels using the same 1% rule. The 1% rule can also be applied to the broader equity, meaning that, at any point in time, the open positions risk is not more than 1% of the entire account balance. This would mean that the total net loss of the open positions (regardless of how many open positions you have) is no more than $100, based on a $10,000 account balance. Some traders use 2%, 5% or more but this entirely depends on how much of risk you are prepared to take.

In summary, the 1% rule can be broken down into the following table:

2. Risk/Reward

The ideal and widely accepted concept for trading is to always take a 1:2 risk/reward set up. This Forex Money Management rule means that if you risk $100 on a trade, then you should ideally make $200 in profit. This is an essential element to money management and one which combines both the money management and the trading strategy aspect. The 1:2 minimum risk reward ratio is used because for every winning trade, you can recover the losses from the previous losing trade and make a profit as well. The 1:2 risk/reward is also beneficial as it can help you recover your losses more gradually as summarized in the table below where we assume a trading capital of $10,000 and follow a 1% money management rule and for a trading strategy that offers 50% win rate.

From the above table, a trading strategy with a 50% win rate can still offer you a $200 profit when applying the 1% money management rule and the 1:2 risk reward set up. Of course, even with a modestly higher risk/reward set up, for example 1:2.5 you could potentially look to higher profits even with a strategy that offers only 50% success.

3. Over leveraging

This Forex Money Management rule about “Over leveraging” is when a trader chooses a very high leverage for their account. (Read more What is Leverage?) It not entirely bad as widely preached, provided a trader knows how to make use of this leverage correctly. Generally, traders who have a high equity tend to use lower leverage around 1:10 or 1:50. But in reality, traders with equity of $10,000 or lower will have to use at least a leverage of 1:100 in order to realize any significant profits in the markets. Leverage, when combined with the concept of margin can be very beneficial. For example, a trader could use a leverage of 1:400 on a $10,000 account but still stick to the 1% money management rule. The advantage here is that by increasing the leverage, there is a wider scope for the margin and thus any adverse price moves will not result in a margin call. However, on the flip side, using high leverage can result in greater losses, and one which was experienced earlier in 2015 when the Swiss National Bank dropped the EURCHF peg which left traders who were over leveraged taking on more losses than their equity balance.

4. Trading with matching instruments

Most traders randomly choose a trading instrument without actually knowing that a decision as random as this can have wide implications on the trade’s money management. For example, trading on exotic currencies where the spreads are usually around 50 pips or more can be disastrous to your trades. You would have to end up compromising on either your money management or accept a less than 1:2 risk reward ratio. By sticking to the most liquid currency pairs or instruments such as the majors, the low spreads can help traders to better manage a trade. In other words, aiming for a 1000 pip profit with a 50 pip spread is more risky than aiming for 1000 pip profit with a 1 or even 5 pip spread. The chart below shows this in detail as we compare EURPLN which has a 70 pip spread while EURUSD has a 2 pip spread.

Instrument Spreads

5. Setting realistic goals

One of the biggest reasons why traders often end up ignoring their trading rules is due to emotions which tend to grow stronger and risk your equity especially after you take a trading loss. Traders often aim for unrealistic goals of expecting to make a 20% return on investments. True, while there are traders who do achieve such goals, it could be that they are more experienced and are trading with a higher equity. For example, a 20% return on $1000 doesn’t account for much when compared to a 20% return on a $10,000 starting capital. Greed is often a strong emotion that needs to be checked time and again and not let the emotions end up ruling your trading decisions. By having a realistic goal, be it daily, weekly or monthly, traders would be able to better equip themselves emotionally by sticking to the trading rules outlined.

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Mr. James A Forex expert writing both technical and general Forex articles, you can read another similar article from James here