Improving your forex money management
This lesson builds on the forex trading beginner strategy. If you are new to forex trading, check out our free beginner strategy if you haven't already.
Solid money management is a key element in becoming a successful forex trader. The financial markets can be volatile and if you add leverage to the mix — as most traders do — the risks involved are substantial.
A strategy that gives you an edge in the markets only gets you part way there, because ultimately you do not know what will happen. Some trades will be winners and some will be losers — the only solution is to consistently take a series of trades based on the strategy.
However, even when you are using a strategy, and you believe that a certain trade has a 70% chance of going your way, there is still a 30% chance that your trading career is over if you risk 100% of your trading account when making that trade.
So what is that maximum that you should risk? As a general and widely accepted guideline, you should never risk more than 1-2% of your trading account for any single trade.
Position size and stop loss are used to manage risk
In order to manage the total amount that you can lose in a trade if it goes against you, you will use a combination of stop loss and position size.
In general, the stop loss is suggested by the strategy that you use. Once you know how far the stop loss is away from your entry price, you can calculate how large your position can be so that you will only lose at most 2% of the amount in your trading account if your stop loss is hit.
Simple money management rule in the forex beginner strategy
In step 3 of the beginner strategy, when we instructed you to enter the volume into your pending order, we gave you a very simple rule for doing so.
The money management rule stated that for every $100 that you have in your trading account, you should trade 0.01 lots rounded down (based on trading a major currency pair, with the US dollar as the quote currency).
We were able to state this because we have tested the results over a significant sample size and found that the average stop loss over these trades came to 12 pips. To account for variations in the stop loss size, we added a margin of error and rounded this up to 20 pips.
For currency pairs quoted in USD, a loss of 20 pips equals a loss of $2 per 0.01 lots traded, i.e. if you had $100 in your trading account, it would equal a 2% loss. Thus, if you trade at most 0.01 lots per $100 under the beginner strategy, you will usually not risk more than 2% of your account in a single trade.
Improving forex money management in the beginner strategy
The simple rule given in the beginner strategy is extremely cautious when compared against the principle that you should at most risk 2% of your account in making a trade. In the vast majority of cases, the simple rule gives position sizes that risk significantly less than 2%, and rarely, it could happen that the risk is higher than 2%.
In order to exactly calculate what position size can be traded so that under your stop loss, the risk is exactly 2%, a bit more effort is required.
To calculate the position size that equals the amount you can risk, you use the following formula:
Position size in lots = (Account size * the % risk per trade)/ (stop loss in pips * value per pip)
Be careful that when using the formula, you make sure that the currency of the numerator and denominator are the same – if not, convert one into the other at the current market price.
Reference table for EUR/USD
Using the above formula, it is possible for you to create an easy table for each currency pair or instrument that you seek to trade.
Using the table
As many people trade the EUR/USD currency pair, we have created such a table below. The table assumes that you do not want to risk more than 2% of your account in a single trade.
To use the table, find the row that represents the amount that you have to trade with. Then when you enter your pending order, find the column that represents the size of the stop loss you have for that position.
When you have the account size and stop loss size, the cell will tell you exactly what number to enter into the “Volume” field when you are entering and adjusting your pending order.
Note that the account size is given in US dollars. If you have your account denominated in another currency, you can determine the corresponding US dollar amount based on the current market rate before using the table.