Chapter 6
Money Management in Forex
Now that you have learnt a few forex strategies and are yearning to put your newfound knowledge to use, this would be a good time to talk about money and risk management which are crucial for all forms of investments, including currencies. With the right guidance, most traders end up finding a profitable system. However, to their utter chagrin, at the end of the month they still find themselves with a loss on their hands. This can strictly be attributed to improper money and risk management.
Forex Money Management in 3 Steps!
There are several stages in currency trading that call for active money management. The first of these you will encounter when opening an account with a brokerage firm. One of the most popular money management advices and one that is bang on is that you should never risk more than 2% of your money.
Step 1: Jump in with this principle
Your trading mantra and discipline should be to never put more than 2% of your money on the line. This not only applies to actual trading, but also when opening an account. So, let us start under the assumption that you have $20,000 in discretionary funds. Remember a diverse portfolio is one that has the lowest risk levels. So, when you want to allocate a part of these funds to FX investment, consider the 2% rule.
In keeping with it, you should not open an account with more than $400. Now, if you are wondering why not trade with $20,000 when you have it, consider this- what if the broker goes bankrupt? This is not unheard of. This would mean that you lose all your savings on the double.
Even if this does not happen, assume that you take a 20 lot position, but forget to set the stop loss. If the market goes against you for 100 pips, you will have wiped out all your savings in one trade and you certainly don’t want to do that. The prudent advice here is to always keep enough resources to come back to fight another day. If you are particularly confident, you can raise the bar to 5% and go for a $1000 trading account.
Step 2: Choosing the right leverage
We have already discussed leverage before. In the FX markets, it is possible to get leverage of even 1:500, but just because you are getting that much money to back your trade does not mean you should take it all. In fact, it is vital to understand that a higher leverage is the easiest way to lose all your money on a single trade.
It is never the broker’s money that is at risk, but yours. Consider a scenario in which you have chosen a leverage of 1:500. This would mean that you could take a position on a standard lot of $100,000 with just $200 of your money. Sounds like a good deal, doesn’t it? But, if you are putting $100,000 on USD/JPY, you will have lost $400, which is your entire account balance, with a movement of 40 pips against you.
On the other hand, with a leverage of 1:100, you only get to buy $20,000 worth of assets. However, a movement of 40 pips in this case would just result in a loss of $80, leaving you with $320 in your account for future trading. However, even in this trade, you have risked 20% of your account balance, whereas our rule was 2% on any trade. This means that the maximum you can put on the line is $8.
Step 3: Take the right position
In the third step, we apply our 2% rule to the trade positions that we take. This means that you only invest as much that setting a stop loss at the right point would make you lose no more than 2% of your capital in each trade. Take the instance where you have an account balance of $10,000, the maximum you can risk here is $200. Regardless of the size of your position and where you place the stop loss, 2% is all you can afford to lose.
So, you need to set your stop loss accordingly. Say you are using a trade setup for EUR/USD where the stop loss is at 100 pips; your position size should be such that the loss of 100 pips should not go beyond $200. Now, let us put our mathematical skills to use here. Let us start with the account of $10,000. You are using a trade setup with a 100 pip stop loss. Since your maximum risk appetite is $200, the value of each pip should not be more than $2 ($200/100).
You may remember that when discussing currency lot sizes and the value of a pip, we learnt that for a mini lot of $10,000 the pip value is $1. So, 2 mini lots, which would be $20,000, would give you the pip value of $2 o you could go with 0.2 standard lot.
However, remember that pip values change depending on the currencies that you are dealing with. In fact the pip value is constant only when USD is involved. So, it is best to use a pip calculator.
Managing stop loss in FX Trading
The right entry point is undoubtedly quite important in the currency market, but so is the right exit point. Limiting your losses is one way to win big. So, keep your risk levels at the minimum. This is where a stop loss will come to your rescue. We learnt briefly about these orders earlier in the book. A stop loss will help you to stop your account from taking a significant hit if the market reverses against the position you have assumed.
Most cautious traders will set the stop loss to breakeven when they are profiting from the position. This way there will be no risk involved in holding the position. Take a look at the chart below:
On the AUD/USD daily chart, you will see that the diagonal resistance line has been plotted. The breakout occurred and the expectation was that the price would continue moving upward. So, a long position was taken at 0.9349. The next candle retested the resistance level and the stop loss was set at 0.9312 and the target was the next resistance level at 0.9715.
While the anticipation was that the AUD/USD would continue its strong uptrend, things did not go as planned and the market lost its momentum to come down to 0.9460 even before it reached our target. Fortunately, the candle did start moving upward again after a brief dip. But, even if this would not be the case, we would still be safe with our stop loss in place.
Using stop loss to breakeven
If you are wondering what would be a good time to set the stop loss to break even. The answer to that is simple as soon as the market moves a few candles in your anticipated direction, place the stop loss, regardless of the timeframe you are working with. If you have set your target at x3 or X4 then go for stop loss for X1 of your stop loss size. This way you can collect some profit.
Risk management In Forex
When investing in currencies, there are two types of risks: account and balance. As its name suggests, account risk will impact the monetary holding in your account with the brokerage. It should always be your priority to minimize this risk. On the other hand, the balance risk is the chance of losing unrealized profits to a bad trade or a subsequent fall in the market. Take a look at the diagram below to understand this further.
If you open your position at price x, you will initially set the stop loss to x-2%x. We discussed this in the last section on how you should only put 2% of your trading balance on the line. The breakeven point is when your profit and loss are equal to zero. This is understandably the level at which the asset has been purchased. So, if the price does not move up, but also does not move down and you decide to sell, your profit and loss would both be $0, barring the money paid for transactions. By doing this, you have minimized your account risks.
Next, you can go after balance sheet risks. As the price continues to move, you take your stop trade order higher. This will protect the unrealized gains from the trade. You can continue to protect your profits by trailing the stop trade order as the price continues its upward trajectory.
Minimizing risks is the way to making profits in Currencies!
It would be almost impossible to talk about the greatest currency traders without discussing the legendary Stanley Druckenmiller. When studying his investment style and strategies what becomes apparent is that his focus was always on preserving his capital by limiting his risks and hitting a few home runs along the way.
According to Druckenmiller, if a trader keeps away from loss making years and has only a few years with 100% gains, over the long term he will have made stupendous gains. In fact, he proved that success is not a matter of luck but sound planning.