In this article, I will be focusing on the importance of Money Management in Forex trading. Successful Forex traders have a larger edge and better money management than unsuccessful Forex traders.
After observing hundreds of amateur Forex traders, I began to discover that their failures can be explained almost exclusively by their poor money management practices.
When trading, the importance of Money Management is underestimated by a lot of Forex traders. It is of much more importance than entry and exit decisions (=timing decisions) will ever be. Very few indicators are better than a coin toss, and if they are, the edge is eaten up by slippage and commission.
Money Management in Forex trading is also called asset allocation, position sizing, portfolio heat, portfolio allocation, cash flow management, trade management, capital management and position management, size management, bet size selection, lot size selection, or even risk control, equity control, and damage control.
Money Management is managing the position size while Risk Management is about managing losses and open profits (unrealized trading returns). Actually I don’t like the term ‘Money Management’ in Forex trading as it also has a very general meaning (it’s also used to describe the “process” of saving, those “learn valuable skills” pages talking about piggy banks and how to teach kids about pay checks).
But ‘Money Management’ tells a Forex trader that he should concentrate his research on how to optimize capital usage and to view his/her portfolio as a whole.
Actually there are (at least) 2 steps to implement proper Money Management:
1) Position sizing is the determination of what (fixed or non-fixed) fraction of a portfolio’s total (or again fixed or non-fixed fraction) equity to risk on each trade expressed in Dollar-, Euro-, Yen-, or Swiss Franc-denominated currency values.
2) Position sizing, on the other hand, is the calculation of how many contracts I should hold in my position once a trade entry is signaled, which basically is a function of the Big Point Value (the number of dollars that a 1-point price move represents) and a rounding algorithm as the number of contracts/stocks can’t be traded in fractions and must be cut down to a whole integer.
Let me show you a clearer picture of money management. Suppose you and I bet $0.20 on a coin flip: Heads, you win, Tails, you lose. Suppose you have $10 of risk capital and I have $1. Even though I have less money, I have little to fear, because it would take a string of 5 losses to wipe me out, unless two brokers get between us and drain our capital by commissions and slippage.
The odds will dramatically change if you and I raise our bet to $0.50. If I have only $1, then I can only afford to lose 2 times. If you have $10, you can afford to lose 20 times.
Many amateur Forex traders take wild risks with a poor money management system. When they lose on their trade, they increases their lot size or position, hope that they can recover their losses made previously and make some profits. This action has caused their capital to be more exposed to risks. This lesson won’t automatically build wealth, but will bring a wealth of experience and knowledge, which will prove invaluable to you if both understood and applied properly. It will steer the course for your success in the global financial marketplace.
If you are too lazy to dig deep to both find and understand this lesson, I would advise to either refrain from trading.