Money Management Rules: The Importance of Setting Strict Thresholds
In Forex, like in other forms of investment, deciding beforehand exactly how much you are going to risk in a trade and when you will be getting out is something of the utmost importance. In Forex more than in other markets, though, novice traders tend to avoid this fundamental step completely.
Money Management as a Part of Your Trading Strategy
You cannot trade without a strategy, and you cannot have a strategy without strict money management rules. One of the reasons why newbies tend to make the mistake of trading with excessive confidence, convinced that they will just "know when to enter/exit," is due to the proliferation of demo accounts in online brokers, which let you invest their "fake money" under favorable conditions to get a feel for how it is like to trade on their platform and convince you to start investing real money with them soon.
Trading on a demo account is like a big game, very useful to learn the basics and test a certain platform, but also quite dangerous in a way. It is not a big deal if you lose $100,000 in fake money, so you tend to be bold and risk more, trying to guess when to enter and exit and often being right.
What these brokers will not tell you, though, is that trading your own money is a completely different story. You will feel really attached to your own money and start never wanting to close a trade: you will get greedy if you are gaining, enormously agitated if you are losing. Emotion will play a huge part in your trading experience.
Controlling Emotion in Forex Trading
How can you possibly take good, informed decisions when you are overwhelmed with emotion, be it greediness or false hope? What did you say? That is right, you just cannot! You will need to learn how to control your emotions: it is not easy, but you just cannot do without it. This is why we have an e-books section dedicated exclusively to the trader's psychology! We suggest you read them and apply their methods and practices in trading.
With experience, you will really understand that what helps you the most with keeping emotions out of trading is having definite rules on how to enter, such as your risk/reward ratio or stop/limit/trailing orders to control your losses or save your profits. If you know you will lose X in the worst case and win Y in the best one, you will have one more huge question mark out of your head.
An Example of Money Management Rules
An example of such rules could be the following:
- Only risk 2–3% of your equity for each trade.
- Place your stop/limits at no more than X pips away for the Y pair on the timeframe Z.
- If you lose more than X% in a single day, stop trading and do not try to risk more by "getting back" to the market the next day.
Hopefully, the previous list has clarified what money management rules are. We purposely kept the rules vague because we do not want you to follow them blindly if you have not understood what is behind them. Good rules come with time, and largely depend on your own trading strategy. However, the first point is commonly seen as a good trading rule to defend you from the risk of a substantial drawdown should anything go wrong.