Forex trading is not only quite challenging, but stimulating as well, and that’s probably because of the extreme risk involved in it. But these things are exactly what make forex trading a thrill and acts like a magnet of attraction for many traders, making them jump headlong into it.
But this is not the problem. The actual difficulty begins when traders start forex trading just for the fun of it. There are thousands, if not millions, of forex traders who do not consider forex trading as anything different than a jackpot or casino, where they can just throw in their dices, rub their hands and voila, millions of dollars come into their accounts at the blink of an eye. Needless to say, this is the most erroneous concept one could ever have about the trade of currencies.
Why Is Money Management So Crucial to Forex Trading?
Forex trading, like any other financial business needs a lot of planning and discipline. It should not be based upon emotions or left to chance even for a fraction of a second. Having a vague outline or a mere skeleton of a trading plan is also not enough.
You ought to have a robust money management system if you actually are serious about forex trading and do not wish to end up frustrated, dejected and bankrupt.
The importance of proper money management cannot be emphasized enough, especially in a high risk environment like forex trading, where you could blink for a tiny moment and millions of dollars could be lost, leaving your financial condition in tatters.
And it is not just about losing or making money. There are a lot more valuable things at stake here, like your mental peace and well-being of your loved ones.
This is exactly why trading systems essentially require a robust money management model to be incorporated into it, and this post is going to discuss at length about the various concepts that could transform your forex trading performance in a positive and beneficial way.
Who Needs Money Management in Forex?
Instead of asking who needs money management in forex trading, it would certainly make more sense to ask, who does not need money management while trading forex. Irrespective of the style of trading you follow, or the number of years you have spent in trading forex or even the amount of capital that you are risking while trading currencies, you still need a disciplined money management plan.
Here are a few benefits of inculcating an organized approach to your finances while trading:
When you are not planned, you stand the risk of suddenly and unexpectedly having to face rude shocks. When you have your financial planning well-organized, you know how much of your money is at stake and this can be known well in advance, long before you actually stake your lots.
So in such a situation, where everything is under control, nothing can take you by surprise and you have your trades going on smoothly. This kind of stability is missing when you are placing lots randomly, based upon your whims and fancies.
Consistency in your risks is going to take out the shock element and you know what to expect. Using stop loss triggers will help you control and foresee your losses (in case they occur later) to the exact decimal and that is what makes you a professional forex trader.
2) No Rebound Effects
When you have burnt your fingers once, you naturally get cautious or let’s say extra cautious when the same situation arises next time. Caution is good but this sort of extra caution has its own disadvantages as well.
If you have lost a lot of money in your initial trades, it is obvious that you will get extra cautious about your subsequent trades and this is going to limit you in a severe way. For example, let us say you actually can afford to lose $ 1000 and have already blown away about $ 800 in the first trade. This will have its rebound effect and you now will limit your risk on your following trade.
When you limit your risk you also limit your profit margins and that is exactly why you are at a loss if you do not have a proper money management system in place.
Stress is not only disturbing but also harmful for your overall health. Trading without a money management system is like exposing yourself to continuous and powerful stress and that is an extremely perilous thing to do.
When you are trading without any planning or system in place to manage your profits and losses, you are actually risking your money and more importantly, your well-being. If you are smart, you would never allow your emotions anywhere near your trading. And that is possible only when you have a clear idea about your projected losses and profits and you are completely comfortable about them.
4) You Can Turn Around Your Failures
When you have a system in place to manage your losses and profits and finances in general, you actually have made yourself more powerful. You now possess the power to turn around your trade in a positive and constructive manner.
Applying even a simple strategy like the ‘moving average crossover trading strategy’ could help you enormously when combined with an organized money management plan. No matter what you do your actual target must be to rake in a positive return on your invested capital and that is possible only when you know how to balance your risk and reward ratio properly.
Advantages of Risk/ Reward Money Management
The most potent benefit of using a systematic money management plan is that it can actually be the difference between your winning and losing trades. By saying this I do not mean that traders who use money management never lose any of their trades.
Instead I wish to draw your attention to the fact that such are successful because their winning trades clearly outnumber their losing trades and that is what matters at the end of the day. Unless and until you understand this concept it is not possible to reap the benefits of this system and that is why you should grasp the details.
Understanding the Risk / Reward Ratio
Risk / Reward ratio is nothing but the balance between your risks and rewards. In simpler terms, it just denotes the ratio between your amount of money you are prepared to lose in case of a losing trade and the amount of profits that you are targeting.
To understand this concept better you would need to see some examples. Let us say for instance that your opening capital is $100. You are trading all of this with an intention of raking in a profit of $500.
In this example your risk is 1 and reward is 5 and the ratio between them is 1:5. Similarly, if your opening amount is $ 5000 and you want a profit of $10000, then your risk to reward ratio is 1:2.
A good money management system will utilize an appropriate risk to reward ratio also known as R:R. When you are placing random lots, without any prior planning or understanding, you are actually playing with fire and you stand the risk of burning yourself anytime soon.
Money management not only involves organized and planned way to trade but also to find the best R:R and employ it on a consistent basis so as to maximize your profits and minimize your losses, if not deleting them altogether.
Perils of Negative R:R
If positive R:R possesses immense power to uplift your trades, then it is obvious that a negative R:R will certainly be perilous. To illustrate this in detail, let us consider a scalper who aims for small range of profits and rapidly goes in and out of his/her trades to avoid major fluctuations of the market. In our case let us say this scalper has aimed for a 3-pip profit.
Now if the risk to reward ratio that he/she is employing is 1:2, then to achieve 3 pip profit, a risk of 1 has to maintained, which means that the stop loss must be placed at 1.5 pips. Again, if the R:R ratio used is say, 1:3, then the stop loss must be placed at 1 pip in order to gain a 3 pips profit.
For a scalper it becomes almost impossible to trade in such an environment because the market keeps vibrating constantly and it is common to see fluctuations of at least 5 pips at most of the times.
This means that a scalper who has set such R:R as in above examples would rapidly be ushered out of the market without achieving anything much in terms of profits, because his stop loss placements are extremely close and do not give sufficient room for the trade to progress and achieve the 3 pips profits that was originally aimed at.
Now this is where the negative risk to reward ratio comes in. Scalpers are extremely notorious in their usage of such negative R:R. A negative R:R means that the risks outweigh the rewards immensely. Scalpers are like gamblers who put out a lot more of their capital and expose it to high risks in order to achieve a targeted reward, which is not only foolish but also dangerous.
So a scalper using a negative R:R may decide to aim for a 5 pips profit, but is forced to risk at least 20 pips to give his trades the space to accommodate the market vibrations. This means that his R:R is at 4:1. So his stop loss placement is now at 20-pips and he will settle for a profit of just 5 pips.
This situation is extremely dangerous because in case of a loss, he will have to win the next 4 trades in a row to cover the loss of 20 pips. And if misfortune prevails and he loses one more trade then he has to win the next 8 trades in a row to mend everything up. And this is how things start going downhill at a rapid pace.
While no forex trader with even an iota of financial sense will ever taint his/her trades with a negative R:R, there are hundreds and thousands of traders who indulge in such extremely risky ventures day in and day out. Then is there any wonder that people keep saying that forex trading is risky and people rarely, if ever make any money in it?
The real truth is that forex trading is no doubt risky, but it is the rash traders who are piling on the risk factors and multiplying the risk manifold times by ignoring money management and using a negative risk to reward ratio.
Ways to Maximize Positive Risk Reward Benefits
Now it is quite clear that effective money management and usage of a positive risk reward ratio is highly crucial for forex trading success. As is evident at this point, positive risk reward implies that the trader is targeting to earn more profits than he/she is prepared to lose or risk.
The best part about using a positive R:R is that the trader gets more flexibility and can afford to take more stop loss hits than the scalper who is using a negative R:R. Positive risk reward benefits can be maximized upon understanding in deeper detail about how they affect your trades.
In the table below we compare risk reward ratios and how many trades you can afford to lose before suffering a loss.
|Risk/Reward Ratio||Percentage of trades you can lose to break even|
To illustrate further it is necessary to take examples like we did to understand about negative risk reward ratio. Let us consider that a certain forex trader uses a positive R:R of 1:1. This means that he can afford to lose 50% of his trades without harm. Similarly, a risk to reward ratio of 1:2 allows to lose 66% of the trades and a ratio of 1:3 allows for 75% losses and a ratio of 1:5 permits 83% losses and so on.
It is obvious that an R:R of 1:3 is optimum and especially recommended for newbie traders as well. Aiming to earn 300% in profits allows the trader to lose upto 75% of the trades without harm and this means that he needs to win only 25% of the trades to break even and in case he wins 26% of his entire trades, he can start earning profits.
I am sure now you can understand the benefits of including a solid money management system in your trading system, and then even further improving the performance of your trading by introducing positive risk reward profiles.
A robust money management system and a positive risk reward profile will enhance the performance of your trades and minimize losses.