Money Management and Risk Management in Forex Trading

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Even when there is immense love between the Couple still the success of a relationship depends on how much effort a person gives to make the partner happy. And the person has to also see how much he/she is getting in response. If, the persons is putting enough efforts to make the relationship work and also getting proper reward from the partner for his efforts then the relationship would work. Likewise, in Forex trading too we might have the best trading system which has given big profit in the past and is giving profit in the present. But if we are not trading our Account with proper Money management and Risk management then we are going to fail eventually. Let’s know the importance of proper Risk and Money Management in Forex.

We worked hard, analyzed many charts, many indicators, support/resistance, and came up with a good profitable trading system. We back tested it for last six months, and found it gave us profit. Great job. You are a Champion. But you are yet to win the trophy. You just gained the skill to win the trophy. But to actually be a Champion you need to play the match, overcome the difficulties, and be a winner. In our case we have to trade live, see off the difficult loss making period and come out as a profitable trader. But to be in that position we have to have proper Risk and Money Management.

Let’s say we found in our last six months testing the highest draw down we had in terms of pips in our system was 500 pips, and average net profit was 250 pips per month. It’s still a great system even though the average draw down is double than the average monthly profit. It’s simple our system ending each month on an average in profit, so even if the draw down is bigger than the profit, it doesn’t matter. Now, we need to see how Money management and Risk management can make or break our trading Account.

Scenario 1- We have 300$ in our Account, we put 0.10 lots per trade at 100 leverage where one pip is 1$.  We need 100$ to open 0.10 lots. We made 200 pips profit in first 10 trades. Great our Account is now 500$. Then the loss streak started and we faced our highest draw down of 500 pips which is a loss of 500$. Now our Account is 0$ in balance.  Our Account is wiped out. We can’t trade anymore. Then we kept on forward trading the system on paper and found out our system worked great covered the losses and ended the month with 250 pips profit. But we ended the month with 0$ when we had started with 300$,

Scenarios 2- We have 300$ and we put 0.01 lot at 100 leverage. Here pip value is 0.10$. We started facing the highest draw down in the start. So, we faced 500 pips loss or 50$. Our Account is now at 250$. To trade 0.01 lots we need just 10$. We have 250$, many more times equity than the need. We kept on trading our system, it covered the losses, and we ended the month with 250 pips profit which is 25$. We ended the month at 325$ with a 25$ profit which is 8% profit in one month. Great result.

From above we can see we traded both the Accounts with the same system same way but one Account ended with 100% loss while the other one ended with 8% in profit. So, now we see the importance of proper Money management. No matter how good our trading system is we would face a series of losses and we have to be ready for that. Never ever allow your Trading Account to go beyond 20% draw down. That’s not accepted under any circumstance. So, see what the historical cumulative draw down was as per your system in last six months, add another 100 pips for safety as our future highest cumulative draw down. Then plan your Money management. Let’s say we found our highest draw down was 600 pips and monthly average profit was 400 pips in last six months as per our system. Then we would add 100 pips to our highest draw down of 600 pips. So, 700 is our new maximum draw down. Trade like this- 0.01 lot for every 400$ in the Account, at 100/50 leverage. So, even if we see 700 pips draw down our Account would still have only 17.5% loss. And as we are ending with 400 pips net profit each month, thas 10% monthly profit. Likewise if our system gave us only 200 pips maximum draw down in last six month. Then add 100 pips to it. So, total 300 pips expected maximum draw down. Our money management would be 0.01 lot for every 200$ in the Account at 100/50 leverage. So, if we faced 300 pips draw down that’s only 15% draw down. And as the system is giving 200 pips average net profit per month then we would end each month with 10% profit. Very impressive and commendable. So, plan your Money management as per the above examples based on the highest cumulative draw down of your respective trading systems.

The 2 main objectives of proper Money Management are,  1- We need to be sure that we have enough equity in our Trading Account to keep on trading and cover the losses and make net profit, 2- We need to keep the draw down inside acceptable limit to avoid unwanted mental pressure. A draw down of 50% in Account would give any good trader sleepless nights, even when his system is very profitable on long run.

Risk Management:

 It’s taken care of first before Money management. Risk management is planned while developing a profitable trading system. Forex trading is a probability business. So, the more powerful we plan our system with high probability the better our chance would be to make profit long term. Always, keep your winning trade size minimum 2 times than the losing trade. In other word our take profit should always be minimum 2 times more than the stop loss size. For every 1$ we are risking in case of a loss we should make 2$ minimum in winning trades. That way, even if we win only 40% of our trades we would still be profitable. This is putting us in advantage even before placing a trade. But don’t use too big profit size as that might be hard to achieve with regular frequency. The best win to loss ratio is 2:1 and 3:1 ratio.

So, now with a good trading system proper Money and Risk Management we are on our way to make constant return from Forex trading.

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Disclaimer- Like any other business Forex Trading too comes with certain risk. One might lose money if not done properly. Never invest money you can’t afford to lose. That’s the first rule for any business. Forex Trading is not suitable for everyone