Money Management with Forex Trading

A lot of forex traders enter the game with no real chance of doing anything but quickly losing all of their money. Forex brokers spend quite a bit of money on recruiting new traders and they need to because so many traders quickly go broke and leave the game.

It takes some real skill to profitably trade forex or trade anything profitably, although with something like trading stocks the amount of leverage you can use is very limited and going broke with stocks is more a matter of attrition over time than blowing up.

Ultimately, if you are trading with a negative expectation, meaning that you both haven’t figured out how to trade profitably yet and you aren’t able to execute a winning plan properly, you will eventually lose all the money in your account or get to the point where the amount you have left is not sufficient to trade.

The real difference with trading with high amounts of leverage is the potential for this disadvantage to be greatly magnified, meaning that you have less time or far less time to figure things out before you run out of money.

There is also the threat of drawdown risk that needs to be managed with all forms of trading, and this is especially a threat with highly leveraged trading such as forex. Even the best traders need to carefully manage drawdown risk. All we are doing when trading is managing probabilities and trading when they are in our favor, and there is always the risk that the probabilities may be distributed against us for a time and we need to be able to get through these times with an acceptable amount of damage.

The first task is to get to the point where you have a profitable trading plan and are executing it properly, and then you can look to ensure that drawdowns are kept acceptable. As we progress to this point, money management is going to be extremely important to allow for your account to survive long enough to get you beyond the negative expectation that most forex traders have to the point where you actually do have a positive expectation from your trading.

Comparing Forex Trading with Other Forms of Trading

Many may think that the number one reason, or even the sole reason, that the majority of forex traders don’t survive even the early stages of their forex trading experience is that they just aren’t good enough traders.

This is true, but it’s not the reason why forex traders fail at all. The real reason is improper and usually terrible money management. No matter how terrible a trader you are in fact, even a small deposit is sufficient to keep you in the game for as long as it takes for you to become good enough.

We can even say that lack of skill is never the reason for a trader’s failure with trading forex at least, even though it clearly is with other types of trading such as with things like stocks or futures. The real reason is that trading stocks or futures require certain minimum position sizes, whether this be prescribed or simply a practical matter due to commission charges.

It wouldn’t make sense for instance to trade 1 share of something even though that would be an appropriate size for a trader who hasn’t acquired the necessary skills to trade larger, and the reason is that the commissions per trade would be disproportionately high.

If you’re shooting to make a dollar from a stock trade and it costs you several dollars in commission to trade it, each way, this is not going to make a lot of sense and there’s going to be a certain profit potential and a certain number of shares that even an expert trader will need to buy to make the trade make sense.

While the theoretical limit of stock trading is 1 share, and with some stocks that can only cost you a few dollars, the trading costs involved will require you to instead need to buy quite a bit more than this. The more you have to buy, with a negative expectation, the more money you can expect to lose. This makes it quite difficult to get started in trading stocks unless you have quite a bit of money that you are well prepared to lose, to pay for your stock trading education.

With futures, the problem here isn’t so much with the commissions, because there are trade limits that pretty much require a decent enough size to make sense of these trading costs. However, once again we face the problem of having to commit oneself significantly and expect to lose quite a bit of money while learning.

While we can start out on a simulator, only risking play money, and this is a great idea, there still will come a time where we have to jump into real money trading, and trade simulations can only do so much to prepare us for the added stress involved with real money. When our money is on the line, we’re going to be going through a learning phase and if we’re forced to expose ourselves to too much risk due to needing to trade larger than we are comfortable with or should be using, this will be a big problem.

The real beauty of trading forex and other contracts for difference trading, where you’re just placing trades with your broker directly, is that this allows brokers to set very low to extremely low minimum trade sizes. You can trade with just a few dollars if you wish with many forex brokers, and this allows us to set our trading risk very low as we look to improve and get good enough to be able to trade with more meaningful amounts, but only when we are ready.

Why So Many Forex Traders Fail

Under these favorable circumstances, it is not the market that does us in when we bust out, it is instead by our own hand. Of course, if we do not understand this, we may think it all happened due to poor trading or may just blame the market or bad luck, but what has actually happened is that we have set ourselves up for failure by not using sensible money management.

Many people trade forex for the excitement of it all, and it certainly can be quite exciting indeed. If the goal is simply to be entertained, to gamble, trading with neither a good strategy, good skills, or proper money management, and we realize that the price of this entertainment will be the money we put in our account, all of it, then that’s fine and good.

There aren’t many forex traders who get into forex trading with this expectation though, or they would just go to a casino, where you can get lucky and win some big money rather than just pursuing a path of doom where the only realistic outcome is your going broke. Instead, what they expect is to both be entertained and to be profitable.

Skilled forex traders who are well funded can indeed enjoy both, and make some very good money and be very entertained doing it. Making money at forex trading is extremely fun in fact. However, this can only happen when one is ready, and trying to seek both of these goals when you are not ready is a terrible idea that will not end well.

Of the two pursuits, the one that involves us being skilled enough in trading forex must always come first. If we seek the fun part to any extent, and especially to the extent that forex traders usually pursue it, before we get the skill part down well enough, this is going to hurt us and hurt us badly.

When we choose to trade larger, this means that whatever probabilities involved in our trading increase proportionately. If we’re skilled forex traders, this means that we will make more money by trading larger, and the only constraints on this will be the amount of money we have in our account and our needing to manage the times where we’re seemingly running unlucky.

There is no luck at all with forex trading or any trading, but there are distributions of probability. The bigger our trading advantage, the less likely we will incur significant drawdowns, because longer runs of losing trades are less likely.

When we have not achieved a probable trading advantage, all increasing our trading size will do is amplify our losses. Losing more rather than less should not ever be and cannot be a reasonable goal with our trading.

How to Manage Money Properly with a Forex Account

The first thing that we need to look at when deciding between forex brokers for money management purposes is their allowing you to use a demo account for a long enough period. Long enough means long enough to be able to be profitable with the simulator.

This is authentic simulation with the only difference being that the money in your account is not real. Everything else is exactly as it would be with a real money account. This is the place to learn to trade.

Some brokers will look to nudge or even pressure you into moving into a real money account. If you run into this, tell them that you will do so when you are ready and if they try to limit you to a certain time period, tell them that this is not acceptable and if they want to do that you will move elsewhere.

The next thing we want to consider is how small of a size that the order system will accept at your chosen forex brokerage. We want to be able to place very small trades if we are newer and still learning. We need to trade bigger only when we are truly ready.

When transitioning from a demo account to a real money account, we want to start very small and show that we do have a good plan or work on it as needed. Forex trading is always a work in progress and even very experienced traders improve with more experience, but newer traders have very little and need to acquire enough to move up to the next step in the ladder.

As you improve and as you show that you can execute your plan and handle the pressures of real money trading, you may move up to higher trade amounts, but do so gradually. While this need not be a very lengthy process, especially if you don’t have a lot of money in your account and losing it all wouldn’t be a big deal, it still pays to make sure that you are able to withstand the risk of a certain trade size relative to the size of your account.

The best traders limit their risk exposure to 1-2% of their account size, and if you are trading correlated pairs such as those which move up and down based upon the value of USD, you need to total these trades in this calculation.

If the best traders do not go beyond 2% with their per trade risk exposure, less skilled ones certainly should never do this. 2% is even too high for a less established and successful trader, and until you get really good at this, capping this at 1% is wiser.

With sensible money management in place, this will give us a time and all the time we need to learn, and also protect us from runs of misfortune once we get there.