The following post is by David Parker from www.easy-forex.com.
Much like eating healthy, exercising, and visiting the dentist on a regular basis, money management is a routine that most forex traders agree on following but not many actually take the step and embrace. The truth is that it takes energy, both mental and physical, to apply these routines but in the long run they will prove highly beneficial.
Money management is divided into two methods. The one involves the assignment of many stop-losses on positions, and the profits from a few large successful trades which will outperform the many small unsuccessful trades. The other instructs the application of very few large stop-losses, and the profits from many small successful trades will overbalance the large unsuccessful trades. For any of the two methods, it is essential for the traders to take note of some considerations for the protection of their trading account balance.
Traders should not be using any funds needed for essential purposes such as housing or car loans, children university fees, or money set aside for any specific purpose because they might find themselves in pretty tight situations. It is no secret that the forex market bears risks and currency trading is more comparable to gambling than long term investing because of its high liquidity. For this reason, forex traders should be using money set aside only for risking in the forex markets and they should not be deprived in case those funds were lost.
Having a firm plan on stop-losses will aid traders, novice or not, to keep away from any emotional decisions such as hope of price reversal during a losing position. The decision of the size of the stop-losses will depend on the fund management method chosen by them. In case of winning positions, traders should let their profits accumulate and the setup of trailing stops is a useful method of doing so.
Understanding the power of leverage changes the traders’ perspectives on volumes traded. Leverage is a common loan given by forex brokers to their clients, from 50:1 up to 200:1 according to different brokers and account types. Even though it initially looks like a risky offer by a forex broker, it is not the case considering that currency prices change by less than 1% during a day. Although there is great potential to increase profits significantly using leverage, it is a double-edged knife. In other words, in case of the price going in the opposite direction, leverage can work as effectively to amplify potential losses and should therefore be accepted in moderation. By keeping this in mind, traders will not be taken by surprise on big losses if the market turns against their open positions.
Sometimes traders open positions which are of higher risk than the level they can handle, and the result is them worrying too much for taking too much heat. Traders will be better off mentally and technically when trading volumes of manageable sizes compared with their overall account fund sizes. Moreover, trading positions with higher risk than the trader’s own appetite is many times the result of greed. This trading sin became the downfall of many otherwise successful traders, not only because of risk overload but also due to overtrading and failure to take profits at appropriate levels. The best way for traders to avoid this type of mistake is to apply safeguards against positions and incorporate them into their trading plans.
Although money management requires discipline, it is flexible and can be applied in many different ways. The bottom line is that there should be a fixed plan on money management to provide the necessary guidelines instead of relying on emotions and ‘feeling’s on how to move within the forex markets.