What is money management in Forex and why it is so important?

Sep 24 • Forex Trading Articles • 1667 Views • Comments Off on What is money management in Forex and why it is so important?

Many experienced and by definition successful traders, are fond of referring to the 3 Ms principles of trading and insisting that you embed these principles into the trading plan you create, a working plan that you should never deviate from, other than with micro adjustments, in order to perfect your overall strategy. You’ll read and hear this critical advice so much, see it printed on so many threads on trading forums and receive it in so many emailed articles, that you’d be forgiven for eventually becoming completely bored with the subject. So much of our trading doesn’t involve actual trading, it involves painstaking preparation and discipline, before we actually place a trade in the marketplace, whilst paying strict attention to the small details and obeying our rules, when we’re then in the market.

As with much advice delivered regarding trading, this critical advice is also extremely easy to ignore, many of us actually believe that we trade abiding by these 3M principles, without actually taking the right care and attention to ensure that we do actually adhere to the simple guidelines and rules of strict risk discipline.

If you’ve come across our 3 Ms guidelines before then apologies in advance, but for novice traders it’s worth quickly repeating that they are; Mind, Money Management and Method. In no particular order these 3 Ms should form the bedrock of our trading and become the critical elements that we then place in our trading plan. Now whilst it’s straightforward to both list and deliver a small description of each of our Ms, in this article, we want to concentrate on discussing what’s understood by money management, which most experienced traders and tutors regard as the most crucial of the three Ms.

 

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We all surmise that we understand what money management actually is, but do we? How often do we take time out to contemplate what this phenomena actually is and then analyze the impact it has on our trading? Do we casually dismiss it as a simple process, without realizing its: complexity, the impact it has on our trading and how critical it is to our trading success?

In simple terms our money management should be regarded as: how we control our trading account, how much do we risk on each trade, what percentage loss can we restrict our self to; per day, per week, per month, or year? What circuit breakers do we embed in our plan, to ensure that we never ruin our chances to trade and that we don’t blow up our accounts, thereby terminally effecting our trading future?

Ask many successful traders why novice traders fail and the vast majority will suggest; poor money management and or a lack of capitalization. Ask novice traders why they think they may fail and they generally suggest that it’s because that they haven’t found, or developed the right trading method/strategy yet. It’s a fascinating paradox and puzzle that novice and indeed intermediate level traders, have difficulty accepting just how damaging a lack of money management can have on their trading, instead believing that once they’ve found the right trading formula, generally a technical indicator complex, their problems will be solved. How to educate novice traders that their risk and money management is key, is often an impossible subject.

It’s frightening to learn that novice traders think nothing of risking 5-10% on a single trade, can lose 20% of their account in a trading session and still fail to take on board the effect excessive risk has on their trading outcomes. One quick re-education method is to ask what experienced retail traders consider to be normal risk and then work forwards as to where, based on simple probabilities, such a risk management strategy could take us, in terms of account growth. And in this example we may surprise many novice traders at just how little you have to risk, in order to embed incredibly tight money management discipline into your training plan, yet still generate substantial returns and account growth.

Let’s surmise that we want to aim for 50% account growth per annum, without taking into consideration compounding and we think we’ve developed a trading method that has a positive expectancy of 2:1, in terms of a win-loss ratio. So we’re aiming for roughly 1% account growth per week. Let’s presume we take three day trades each day, two wins and one loss, we’d need to in effect grow our account by only 0.2% per day on a consistent basis to reach our target. Therefore, based on our 2:1 win loss expectancy, we’d only need to risk 0.2% of our account on each trade, to make exceptional returns of 50% per annum. Now if we gathered together a room of novice traders who were interested in trading, asked them how much risk they’d have to assume to reach trade to make returns of 50% per year, they’d probably shout out “5%, 10%!” And yet to reach reasonable goals, we really only need to adopt reasonable money management discipline.

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