CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage. Between 74-89% of retail investor accounts lose money when trading CFDs. You should consider whether you understand how CFDs work and whether you can afford to take the high risk of losing your money.
Money management is the ability to handle a trading account for a longer period in such a way to increase the chances of survival in the trading environment. The Forex market is known for their wild swings and this adverse environment affects the trading account.
Things like execution and slippage, positive and negative swaps, position sizing, commissions and spreads, risk-reward ratios, etc., are all part or should be part of a proper money management system. The idea behind trading the Forex market is to allow the trading account to grow in time.
There is not possible to have only winning trades, as well as it is virtually impossible to have only losing ones. What is important is for winners to outpace losers and this is what makes the difference between a profitable trading strategy and one that keeps losing money.
Money management is the ability to manage money. This is the plain and straightforward definition of it. While everyone thinks is fit for the job, the reality is a cruel one. Managing money will result in traders fighting with their greatest demons: greed and fear.
Multiple times during the trading day, week and month, traders will question the reasons why they entered a trade if the positions should still be kept open, etc. This questioning is the result of market making moves that were not supposed to happen, or without logic.
This is the norm in Forex trading. A money management system will result in disciplined trading, and disciplined trading will lead to increased chances to profit from these market swings.
Position sizing is the central piece of a money management system. The value of a pip or the volume traded makes the difference here.
A trader can have ten or more consecutive profitable trades, but if only one trade that is ten times bigger in volume is a losing one, then all the previous profits made are lost. As simple as that.
There are multiple approaches to the right position sizing, and the most popular (and effective) is to risk on any given trade only a small proportion of the trading account. No matter the currency pair or the reason to trade, the amount is just a small proportion of the account.
This makes the size of the trading account an important factor as well. However, because we’re talking about percentages, the traded volume will increase or decrease with the size of the trading account. Conservative traders will use around 1%-2% for any given trade, while aggressive positioning within a money management system allows for up to 4% to be risked on a trade.
The currency pairs available for trading are having a strong correlation degree. This is what kills a trading account as it leads to overtrading.
Overtrading means too many trades were open in the same market direction. A small swing on the opposite side and the account suffers irremediable losses.
While position sizing is key, it needs to be considered in strong relation with the currency pair that is traded. If one is selling the EURUSD for a dollar related reason, it is not wise to sell the GBPUSD, AUDUSD and NZDUSD too, as well as it is not wise to buy USDCAD or USDCHF.
It is like taking the same position multiple times. If the reason why the market is moving is a dollar related one, then all those currency pairs mentioned above will move in a correlated fashion.
The result will be that while the trader thinks that is respecting the money management position sizing approach by risking only a small proportion of the trading account on a trade, he/she is not. Because all those positions are correlated, the trading account is having one big bet on the same direction.
This is what makes overtrading and it is one of the common mistakes traders make. Experience plays an important role here and in time these things can be avoided.
There is a whole debate whether risk-reward ratios are a good thing or not for a trading account. The right answer is that proper risk-reward ratios are a must for a trading account.
A risk-reward ratio defines the risk taken on any given trade and compares it with the potential return. The smaller the risk, the more appealing the trade. The bigger the profit, the better the overall ratio.
Easier to say than done. Finding the right risk-reward ratio is subject to multiple factors, starting with the trading style and strategy used, and ending with the currency pair and the time frame for the analysis. Not all currency pairs are moving the same. Some are more volatile than others.
Major pairs (the ones that have the U.S. dollar in their componence) are moving more than crosses (any other currency pair that doesn’t have the U.S. dollar). Consequently, setting a risk-reward ratio of 1:10 (risk:reward) on a cross has little chances to be a good strategy as crosses simply do not move that much.
Such a ratio may work on smaller time frames, like scalping on the one minute and five-minute charts. Crosses can be used here.
Overall, a positive risk-reward ratio is mandatory. By positive, we're referring to any risk-reward ratio bigger than one. That is, for any pip risked, at least one pip profit if expected to be gained.
Example: Long trade on NZD/JPY with a $10,000 account and 2% risk. Should the stop get hit, the account would still have $9,800. If the target would be reached, the account would rise to $10,435. The risk/reward ratio in this case is 2.18.
A proper ratio is anywhere between 1:2 and 1:2.5 and these are realistic approaches for the currency market. That means that for every pip risked, the expectations are that two or two and a half pips are made.
In other words, a trader can be wrong two times and right one time and still not lose money when trading the markets. The bigger the risk-reward ratio, the more chances are to make a profit in the long run.
The three things mentioned here (position sizing, correlations, and risk-reward ratios) are the pillars of any sound money management system. However, they are not the only things to consider, but they are a good starting point to profitable trading.
Chart: Trading View