Risk and money management refers to the measuring and managing the risk of loss and how to make use of your capital in the most effective way. Proper risk management is a key to long-term success in Forex trading.
Below you will find a few useful money management tips that will help you limit the losses and capitalize on your wins:
- Take profit regularly – they say you can’t go broke taking profit. By definition, if you take profit, even partially, you are reducing your exposure to market risk.
- Trade with a Stop-Loss – this is the ultimate risk-limiting tool. Always have one in place for every open position, and don’t move it except for when you protect profits.
- Avoid using too much leverage: essentially, leverage must be only used if you keep the size of any potential losses firmly in mind.
- Do not add to a losing position: If you think the market will eventually turn, let it run its course, but do not increase your risk while you’re in the red.
- Do not risk more than 2% / trade: this is the most common, and also the most violated rule in trading; respecting it will “keep you in the game” even after strings of losses.
The Risk-Reward Ratio refers to the amount of profit we expect to gain on a position, relative to what we are risking in the event of a loss. A simplified calculation of the risk-reward ratio would be to count the number of pips from the entry point to the stop loss and compare the result to the number of pips until the take profit level.
In general, you should not enter a trade unless the risk you foresee is less than half or half of what your anticipated reward will be. This defines a 1:2 risk-reward ratio and it implies risking one pip to potentially earn 2 pips.
That brings us to the consideration of position sizing – the size of the position we are going to take when opening a trade.
Given our 2% rule of maximum risk per trade, that will require us to choose our position size in a way that if the market hits our stop loss, we don’t lose more than 2%.
– We have a EUR/USD setup that requires a 40 pips stop loss;
– We have a $10 000 account. Risk per trade is $200 (2% x 10 000);
– a $200 risk allows us a position size of 0.5 lots EUR/USD ($200 / 40 pips = $5/pip)
In this situation, if we go for a 1:2 risk-reward ratio, our target will be twice our risk: 2 x 40 pips = 80 pips. Consequently, a successful trade will earn us $400.
Keep in mind: trading in the Forex market should be treated like any other business – with risks and rewards involved. That’s why you should have a sound trading plan that incorporates good risk and money management principles.
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