Perhaps the most under-rated area when trading the currency market, money management is, in fact, the one thing that makes the difference between losing and winning. Profitability is the way traders keep score, but money management is the tool to achieve it.
Managing money sounds like an exotic occupation, but every trader becomes a money manager the moment the trading account is funded. For the retail traders, the main reason why they fail is lack of money management skills.
What Makes a Sound Money Management Plan?
Like almost everything in life, skills can be learned, and an active trader on the currency market will be better off respecting the following money management rules:
Change the focus
Every single trading plan or strategy starts from how much the account is about to profit from a single trade. However, the center should be on how to minimize the losses, instead of emphasizing the profit. For this reason, a trader is better off if he/she focuses on the potential loss rather than on the winning side of a trade. To do that, it is mandatory to use a stop-loss order for every single trade in the currency market.
Use Risk-Reward Ratios
Risk-reward ratios refer to the balance between the profit to be made in comparison to the potential loss. Ratios bigger than 1:2 are awesome, and consistency is critical, meaning that traders should not change the ratio under no circumstances.
Overtrading is a frequent cause of failure in the retail market. Because many rookie traders don’t know what overtrading is, they end up finding out when the account sinks to levels close to traders receiving a margin call. Overtrading appears as a direct cause of trading correlated assets. Forex brokers these days offer access to many other markets, making it tempting to open trades on other assets. However, many are correlated (like oil and the Canadian Dollar – direct relationship, JPY, and the DJIA – inverse relationship) and traders double the exposure by taking two trades that have the same effect on the trading account.
Moreover, even the currency pairs are correlated (USD pairs, AUDUSD and USDCAD, etc.), making it difficult to pick the right trade. One way to solve overtrading is to avoid opening trades on correlated pairs at the same time. More precisely, if you are to trade correlated markets in the same direction, wait for a while until opening a new trade. The more the waiting, the less correlated the trades will become and the bigger the chances overtrading is avoided.
Use Percentages to Set the Risk
Percentages are a great way to keep things under control. By risking only one or two percent maximum per each trade, the account has more chances to survive the test of time and avoid being part of the terrible statistic showing that most retail traders fail on their first deposit. In fact, even if losing seventy-two consecutive trades will end up with only depleting half of the account if the one percent rule is in place. Or, if any trader is up to such performance, perhaps trading the currency market is not the right path to take forward.
The way traders handle the pressure when trading is key to success. Both failures and winning trades create an emotional rollercoaster difficult to handle. Money management exists to make it easier to handle the emotions and thus to protect the funds in the trading account.