Money Management Styles and Methods in Currency Trading
The best way to practice successful money management in Forex is for an investor to keep losses lower than the profits they make. This is called risk to reward ratio.
High Reward to Risk Ratio
This method is used to increase the profitability of an investment strategy by trading only when you have the potential to make more than 3 times more than what you are risking.
If you invest using a high risk reward ratio of 3:1 or more, you significantly increase your chances of becoming profitable in the long run. The Chart below shows you how:
In the first example, you can see that even if you only won 50% of your currency transactions, you would still make a profit of $10,000.
Even if your win rate went lower to about 30% you would still end up profitable.
Just remember that whenever you have a good risk to reward ratio, your chances of being profitable are much greater even if you have a lower win percentage.
Never use a ratio where you can lose more pips one trade than you plan to make. It does not make sense to risk 1,000 dollars in order to make only 100 dollars.
Because you have to win 10 times which makes 1,000 dollars back.
If you ONLY lose once you have to give back all your profits.
This type of investment strategy makes no sense and you will lose on the long term, guaranteed!
The percentage method is a method where you risk the same percentage of your account balance per transaction.
Percentage based method says that there will be a certain percentage of your account equity balance that is at risk per trade. To calculate the percent per each transaction, you need to know two things, the percentage risk that you've chosen and lot size of an open order so as to calculate where to put the stop order. Since the percent is known, we shall use it to calculate the lot size of the order to be placed in the market, this is known as position size.
If you have an account balance of $50,000 in your account and risk percent is 2%
Then 2 % is equal to $1,000
If three investors buy EURUSD and the first one is using 20 pips stop loss, second one is using 40 points stop, third one is using 50 points stop, their position size will be:
Stop loss = 20 pips
Risk percent = 2 % = $1,000
20 pips = $1,000
1 point =1,000/20= $50
Position size is 5 lots (for 5 lots 1 point movement =$ 50)
Stop loss = 40 pips
2 % = $1,000
40 pips = $1,000
1 point =1,000/40= $25
Position size is 2.5 lots (for 2.5 lots 1 point movement =$ 25)
Stop loss = 50 pips
2 % = $1,000
50 pips = $1,000
1 point =1,000/50= $20
Position size is 2 lots (for 2 lots 1 point movement =$20)
Example: If an investor with $50,000 wants to calculate annual income from his strategy
Annual income: If your trading system has a win ratio of 70% and your risk reward is 3:1, and your stop loss is 30 pips and take profit is 90 pips and every month you make 20 transactions trading standard lots, then you maximum annual income will be about:
For 1 standard lot profit per 1 pip is $10
20 transactions*12 months = 240 transactions
Wins and Profit
70% win : 70% of 240 = 168 profitable transactions
168 transactions * 90 pips = 15, 120 pips
15, 120 pips = $151,200
30% win : 30% of 240 = 72 losing transactions
72 transactions * 30 pips = 2, 160 pips
2, 160 pips = $21,600
Net Profit = 15, 120 - 2, 160 = 12, 960 pips
Income: 12, 960 pips = $129,600
The above is just an example, the amount you will make will depend on the risk: reward ratio of your Forex system along with it's win percentage ratio.
Other factors to consider include:
Maximum Number of Open Positions
A final point to consider is the maximum number of open positions that is the maximum number of trades that you want to be in at one time. This is another factor to decide when managing capital.
If for example, you chose a 2%, you may also say chose to be in a maximum of 5 positions at any one given time. If all 4 of those positions close at a loss on the same day, then you would have an 8% decrease in your account balances that day.
Invest Sufficient Capital
One of the worst mistakes that investors can make is attempting to open an account without sufficient capital.
The trader with limited capital will be a worried investor, always looking to minimize losses beyond the point of realistic trading, but will also be frequently taken out of the transaction before realizing any success out of their strategy.
- Exercise Discipline
Discipline is the most important thing one can master to become profitable. Discipline is the ability to plan your work and work your plan.
It is the ability to give a trade the time to develop without hastily taking yourself out of the market simply because you are uncomfortable with risk. Discipline is also the ability to continue to stick to your plan even after you have suffered losses. Do your best to cultivate the level of discipline required to be profitable.
Managing Account Capital Basics
Money management, is the foundation of any trading system as helps investors to get profit transacting on the foreign exchange market. It is especially important when transacting in the leveraged currency market, which is considered to be the most profitable financial market but at the same time the riskiest, because in Forex there are more probabilities to making profit than the probabilities to make losses.
If you want to invest successfully in the currency market you should realize that it is very important to have an effective strategy of money management because you will be using leverage to place your orders.
The difference between average profits and losses should be strictly calculated, the profits on average should be more than the the losses on average, otherwise trading will not yield any profits. In this case an investor has to formulate their own rules, success of each person depends on their individual traits. Therefore, every investor makes his own strategy and formulates their own money management, based on the above guidelines.
When you are placing your orders put your stop orders in order to avoid huge losses. Stop orders can also be used to lock in profit and get additional profit.
Consider the chance to get profit against loss as 3:1 - this ratio should be favorable more on the profit side.
Considering these rules and guideline, you can use them to improve profitability of your strategy and try to develop your own strategy that will possibly give you good profits.