Forex Money Management

Money management in the context of Forex trading refers to the process of analyzing trades for risk and potential profits, determining how much risk is acceptable and managing a trade position to control risk and maximize profitability.

Stop Losses.

There are no absolute rules to how to implement a money management strategy. However, some of the keys are to only risk a small percentage of your total equity capital on each trade. That way, you are able to recover from an unprofitable trade. Moreover, you may want to always have an actual stop set for each position. That way, you can assure that your losses from unprofitable trades are always limited in some predefined and controllable manner. Taking these steps and others can help limit the drawdown that you may suffer at any one time. One well known trader suggested a stop loss set 3% below your entry point; he then indicates that once your position has appreciated 3%, that you move your stop loss to your original entry point. For a full discussion of these rules and many useful other money management concept, see W.D. Gann’s famous book How to Make Profits In Commodities which was published many years ago.

Drawdown is simply the amount of money you lose trading, expressed as a percentage of your total trading equity. For example, if you funded your trading account with $20,000 and proceeded to lose $3,000, you would have suffered a drawdown of 15% ($3,000 divided by $20,000). To get back to breakeven, you would now have to obtain a positive return of 17.65% on your remaining equity capital ($3,000/$17,000). As you will see, as the size of the drawdown increases, the going forward positive return percentage increases exponentially:

5.00% - 5.26%
10.00% - 11.11%
15.00% - 17.65%
20.00% - 25.00%

Thus, the greater the drawdown, the more difficult it is to get back to a level of overall profitability.



Risk-Reward Ratios.

Other money management items include making sure any preplanned trades have an adequate risk-reward ratio such as 1:2. For example, if you sold the USD/CAD pair at 1.1723 and set a stop loss at 1.1823 risking a 100 PIP loss, you should not sell the position if it moves in your favor unless the price is 1.1523 or better (representing a 200 PIP profit).



Do Not Close Profitable Positions.

If you have the discipline, you should not sell your profitable positions even if they move past your risk-reward threshold level (1.1523 in the example above). Instead, you could hold onto the position and progressively move your stop to lock in your profits. For example, if the USD/CAD pair moved to 1.1475, you might place a stop loss at 1.1523 to lock in your 200 PIP profit. By doing that, if the market continued to move or trend in your favor, you could continue to profit from the trend. You could also continue to move your stop loss to lock in additional profit. The trailing stop feature can be useful to accomplish this and remove the need to continuously update your stops and instill a sense of discipline to your trading.