Money Management Rules: The Importance of Setting Strict Thresholds
admin on August 14th, 2008
In forex like in other forms of investment, deciding beforehand exactly how much you’re going to risk in a trade and when you’ll 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 can’t trade without a strategy, and you can’t 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’ll 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 (more on that in one of our next articles) to get a feel for how it’s like to trade on their platform and convince you to start investing real money with them soon.
Trading 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’s 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 won’t tell you, though, is that trading your own money is a completely different story. You’ll feel really attached to your own money and start never wanting to close a trade: you’ll get greedy if you are gaining, enormously agitated if you’re 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’re overwhelmed with emotion, be it greediness or false hope? What did you say? That’s right, you just can’t! You’ll need to learn how to control your emotions: it’s not easy, but you just can’t do without it. This is why we have a section on our eBooks page dedicated exclusively to the trader’s psychology! We suggest you read them (we currently have only two psychology-related books, but we’ll add more soon as we gather more author’s permissions).
With experience, you’ll 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’ll lose x in the worst case and win y in the best one, you’ll 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 for the Y pair, at the Z candlestick graph;
- if you lose more than X % in a single day, stop trading and don’t try to risk more by “getting back” to the market the next day;
- etc…
hopefully the previous list has clarified what money management rules are. We purposely kept the rules vague because we don’t want you to follow them blindly if you haven’t 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.
