Trading the forex market without safeguards can be like skydiving without a parachute. Anyone serious enough about trading would do well to incorporate money management techniques to their trading plan to protect their portfolio.
Nearly all successful traders use a money management strategy along with their regular trading plan, and if you have ever experienced a severe drawdown on your account, you probably do too.
Basically, having safeguards in place to protect your account to remain in business is far better than the alternative. What follows are some general guidelines for money management which can be incorporated into a trading plan.
Tip #1: Only Trade With Risk Capital
Trading currencies involves taking substantial risks, no matter how you look at it. Because of the free-floating currency market, currency trading has considerably more in common to gambling than investing.
As a result, putting funds at risk which you cannot afford to lose should never even be considered by a responsible forex trader. This includes money needed for key housing expenses such as your mortgage or rent payment, or the weekly food allowance necessary for your or your family’s sustenance.
In general, traders do better by only trading forex with funds known as risk capital. Such money has been specifically designated for trading because it is expendable and therefore not needed for the basic essentials of living.
Tip #2: Cut Losses Short, Let Profits Run On
These just have to be some of the most popular words of wisdom that Wall Street has ever passed on to its novice traders.
The basic idea behind this saying is that you should first endeavor to manage your risk by using stop losses in a disciplined way.
Secondly, you should also allow your profits to accumulate when you have a winning position. Traders often use trading stops for this purpose.
Furthermore, as a wise trader once said, “In trading, it’s not what you make, profits take care of themselves; it’s what you don’t lose that really matters.”
Tip #3: Avoid Using Too Much Leverage
Because of the nature of the forex market as a venue of exchange for currencies, initiating a forex position involves the equal value exchange of two currencies. This requires no money initially, in theory anyway, because it is not a purchase or sale of a commodity or stock, but instead represents a rate of exchange.
Most online forex brokers therefore offer their customers leverage ratios which can be as much as 500:1. This means that for every dollar you place up as collateral against potential losses, you can control $500. While this sort of leverage can be extremely profitable on a winning transaction, it can also deplete your account just as quickly, cleaning it out in just one sharp forex move. (In the U.S. the maximum leverage is 50:1 for majors and 20:1 for minors.)
Essentially, leverage must be only used if you keep the size of any potential losses firmly in mind. This way, your portfolio will not suffer severe, unplanned draw downs if you find yourself on the wrong side of the market, as almost all forex traders do at one time or another.
Tip #4: Avoid Taking Too Much Heat
The heat factor when trading consists of how comfortable you feel with the amount of risk you have assumed on any given position.
Essentially, if you cannot sleep at night because you find yourself worrying about your forex trading positions, then you will generally be taking on too much heat in your trading portfolio.
Heeding this tip involves only taking positions you feel comfortable with and keeping your trades to a manageable size in proportion to your overall account size.
Tip #5: Do Not Give in to Greed
Maybe “greed is good” as Gordon Gecko, the fictitious trader modeled after Ivan Boesky once maintained in the classic financial markets movie “Wall Street”. Nevertheless, greed has been the downfall of many a successful trader.
In fact, greed leads to a number of risky trading errors. These include: overtrading, excessive risk taking and failing to take profits at appropriate levels.
One of the best ways to deal with greed when it inevitably arises when trading forex involves having appropriate safeguards against it built into your trading plan.
Use the above tips in Your Trading Plan
By trading objectively through having a sound trading plan and incorporating the wisdom contained in the above money management trading tips, you will be far more likely to be profitable in the long run than if you traded based on your emotions and without any plan at all.
Perhaps even more important is maintaining the discipline necessary to follow your plan once you have made it.