Forex Money Management: Strategies, Procedures
In this lesson we will examine the subject of forex money management and how to manage trades and profits as a forex trade proceeds from the point of entry to the exit.
What Is Forex Money Management?
Forex money management is a set of specific procedures to minimize any trading losses and capturing profits that can be easily implemented on all trading platforms. We also believe that other things like a good knowledge base and having a great trading system are part of an overall money management program for your trading.
Is Forex Money Management Necessary?
Yes, if you have an effective trading system and are implementing it correctly. Most forex traders think money management is of utmost importance, this is because in many cases the trading system they are using is ineffective. There are three possible scenarios.
Scenario 1 - If the forex trading system you are using is ineffective and does not consistently give you positive pips with demo trades, then you do not need money management because you will never see any positive pips on your demo or live trades anyway, it is pointless to apply forex money management to an ineffective trading system.
Scenario 2 - If the forex trading system you are using is effective at making pips but you are not implementing the system the way it was designed to be used, once again your demo trades will all be losers. Once again it is pointless to apply money management until you learn to apply the system correctly.
Scenario 3 - If the forex system you are using if effective at making pips and you are implementing the system correctly, your demo trades will have overall positive pips. In this case forex money management becomes important, and more importantly, profit management. In this scenario have to learn to manage the money and profits and the occasional small losses or break even stop outs that will sometimes come with any good and profitable forex trading system.
I have heard a lot of forex traders say how important forex money management is, but this is relative. The moral of this story is quite simple, find an effective forex trading system that makes positive pips before you even think about money management. Forexearlywarning has a complete trading system that produces pips when properly implemented, so money management and profit management is important to us. Having a proven forex trading system that produces pips is, in itself, effective money management.
Forex Money Management Versus Profit Management
As we have now pointed out, money management is of relative importance. If the forex trading system you are using is ineffective you will lose on all of your demo trades even if you use good forex money management. If you have an effective forex trading system and you study the system and use it correctly then profit management becomes vital so that you are now able to capture those profits.
How do you determine if a forex trading system is effective and is profitable? By demo trading, there is no other way. Demo trading is boring, losing all of your money will be very exciting. Demo trading is good money management. Not doing any demo trading will prove that quickly.
If you come across a forex trading system and you do not demo trade the system to prove that the system works, greed and ego on the part of a forex trader are now in control. Let’s be sensible and commit to demo trading as part of an overall money management mindset. After you have a good level of success paper trading, with a forex trading system that works, then the next step is to start trading with small amounts of real money using micro lots. This way a trader can get a feel for the forex market with a small amount of money at risk and emotions will stay out of the decisions. When a trader does this they can practice scaling out lots while trading micro lots into profitable movements to practice capturing profits, building good profit management habits. This will better prepare any trader for higher quantities of lots and full scale lots trading.
Forex Money Management Basics
The basic concept of forex money management is that for each pip you risk you want to make X number of pips. This is called your money management ratio. If you trade with the right money management ratio and have only 50% trading accuracy you still make a lot of pips, and possibly a lot of money. If you know your money management ratio for a particular trade as well as the pip potential you can decide whether or not to take a trade well in advance and possibly not take the trade at all. Always know your forex money management ratio. If a trade has 100 pips of potential and you enter the trade with a 30 pip stop at the outset, then the money management ratio is 100/30 or +3.3 to 1 (positive). The higher the money management ratio is, the better.
Some forex trades outlined by the Forexearlywarning trading plans have money management ratios of up to +15-20 to 1, or higher, which is excellent. We teach trading the swing to position style and only take shorter term trades when the market conditions dictate this or if this is the only type of trade available.
Even if your money management ratio is +2.0 to 1 positive and if this ratio repeats itself your account will grow, even at 50% trading accuracy, because you make 200 pips for every 100 pips you lose. Using the entry trade entry verification system we present in this article, which is called The Forex Heatmap®, along with the trading in the direction of the trends of the market, we feel as if your money management ratio will be much higher than +2.0 to 1.
On the other hand, the risk reward ratio for scalping the forex when trading is negative. It is mathematically impossible to make money scalping and you will wind up losing your mind and your money doing it. It will wear you down mentally. Here is an example of how scalping for 10 pips is negative money management. Your goal is to make 10 pips and your stop order is set at -30 pips, this is a negative forex money management ratio of -3 to 1. Very bad.
In this example the typical forex scalper has a -3 to 1 money management ratio, remember that is a negative money management ratio. Some scalpers trade without a stop and over leverage risking their entire account. This is high risk gambling and your account and financial future is at risk. If you trade 1 regular lot, the risk amount is always the same only the variable is the potential reward amount, this is why scalping can never work with negative money management.
By contrast, if your forex trading style is swing to position trading, where your goal is to stay in the trade for several days at a minimum, then your money management ratio is positive and ranges from about +2.5 to 1 and up to as high as +20 to 1 which is outstanding. Money management ratios of about +5 to 1 or larger regularly occur on the larger time frames and trends. Fresh moving average crossovers on the H4 time frame and larger have very good money management ratios. Combine strong money management ratio with the major time frames and trends of the forex market for best results. Also, if you use The Forex Heatmap® to guide your entries, your accuracy also improves to around 90% positive. This is the correct way to trade the forex and your risk of loss is negligible. This is very good forex money management.
Everyone has losses and some break even stops. It's going to happen. Just keep them small and manageable and with the proper ratio of wins and losses and the proper money management ratio and you will be fine. You will get stopped out at some point, it is a fact of life and part of trading. But even with a 50% success rate and the proper forex money management ratio your account will grow.
Swing to position trading on the H4 time frame and larger is good money management, scalping is poor money management due to the differences in the potential pip reward versus risk. If you trade 1 regular lot on all of your trades the dollars that you risk is always the same only the variable is the potential reward amount changes, this is why scalping can never work with negative a money management ratio. Go for larger trends and time frames and use a quality trade entry management system to avoid this. Avoid scalping the forex with crappy, unproven indicators, it is the road to disaster.
Example Forex Trade Entry and Money Management
One of the best ways to demonstrate good forex money management is with an example. Look at the example trading signals and sell entry plus money management notes below.
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Here is an example of a great trading system where money management can be applied. Here are the notes to accompany the above chart:
As we have discussed, you need a profitable trading system to apply money management. Look at the example trade entry above using the Forexearlywarning trading system. The JPY is strong on all pairs using the Forex Heatmap®, so the CHF/JPY sold off about 90 pips in the example above, in one trading session. This is our starting point for money management, a great trading system that produces pips.
Point number 1 on the chart is the sell entry point. The yellow line on top of the chart is your initial stop order point. At point number 2 on the chart, the pair is dropping. When you reach 30-40 pips of profit you can scale out lots, then move your stop order to break even. You now have zero risk. At point number 3, the CHF/JPY is stalling at intraday support. The trader has two choices: 1) exit the trade completely as a daytrade, or 2) if the CHF/JPY is trending down on the higher time frames, like the H4 or larger, and there is no nearby support, then the trader can stay in the trade for further profits.
Important money management rule: If you enter a new buy or sell trade always use the 30 minutes to 1 hour rule. After a new trade entry, if the trade stalls, loses momentum, and and goes sideways in a +/- plus or minus 15 pips range and you are unable to move your stop order to breakeven, you should always exit. Exit within 30 minutes to 1 hour if the trade goes nowhere. Since we use momentum based trade entries your stops must go to breakeven and you must be in positive pips fairly quickly. Check trends, support and resistance levels and heatmap signals again, you may have made a mistake, or sometimes the market just stalls on its own. If you combine this rule with some stronger trades like the one above your money management procedures will be completely set for most or all situations.
Setting and Moving Stop Orders
In the example above you can see that the CHF/JPY was consolidating and moving sideways before it dropped. Your initial stop order (yellow line) would be directly above the previous consolidation cycle. Most low volatility pairs would use an initial stop of about 30 pips. Higher volatility pairs would use an initial stop order of about 40 pips. To get an idea about what pairs have low or high volatility we have more information on this topic in one of our other illustrated articles, currency pair characteristics.
The next step in trade management process is moving your stop to break even. Because you are using a strong set of signals to trade with, your trade should move into positive pips fairly quickly. When the trade goes into positive pips by about +30 to +40 pips, the trader should move their stop order to break even and scale out half of their profitable lots. Then reassess the trade again later. If your trade has not gone positive or stalls within about 30 minutes to one hour you should exit the trade completely. You can practice this technique with demo trading to get used to it.
These are our basic trade management rules. Our "rule of thumb" is to scale out lots and move stops to break even when the trade goes positive, and our 30 minute rule is for trades that stall or go sideways. If a trade goes sideways and stall just exit the trade completely and re-assess the situation.
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Other Forex Money Management Strategies
Traders can incorporate other strategies into their forex money management programs.
For example forex traders should learn about support and resistance. When a currency pair is approaching a strong support or resistance level, they should scale out lots or exit their trades. Drilling down the charts on 28 pairs using multiple time frames daily is a good strategy, because you will always aware of the market conditions, trending, ranging, or choppy. Knowledge about the forex market, especially how individual currencies affect market movements, is also great to have. At some point traders have to leave technical indicators behind because these indicators have failed them in their quest to make pips.
Conclusions about forex money management: As a first step, forex traders need to make sure their trading system is effective at making pips. Then they can apply money management and stop order techniques to their trades and move forward with steady and consistent positive pips, week after week.