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Forex Trading Money Management – An EYE OPENING Article
An Eye-Opening Article on Forex Trading Money Management
This post was written to expose some truths and some myths surrounding the topic of managing your trading capital. Most information out there on money management is completely useless in my opinion and will not work well in professional trading. What most traders are taught about money management is usually ‘lies’ invented by the industry to help you lose your money “slower” so that brokers can make more commission / spreads from you. If your using the 2% money management rule, this article may put that theory into question, which is the point… to make you think about it from all angles and perspectives. I also believe that people who teach the ‘percentage of account’ risk management method don’t truly understand how arbitrary this idea is. The reason is simple… every traders account size will be different and every persons risk profile, net worth and skill level is different. If you simply take a percentage of money that is in your trading account to risk on each trade, it’s purely arbitrary. What you are prepared to lose or risk on each trade is much more complex than just plucking 2% or 4 % or 10% out of thin air. Let me explain…
I will warn you that what you are about to read is likely to be contradictory to what you may have already learned about forex money management and risk control in other places. I can only tell you that what am I about to divulge to you is the way I trade and it is the way many professional forex traders manage capital. So get ready, open your mind, and enjoy this article on how to effectively grow your trading account by effectively managing your money. Just remember, everything I talk about on this website is based on real world application, not recycled theory.
Everyone knows that money management is a crucial aspect of successful forex trading. Yet most people don’t spend nearly enough time concentrating on developing or implementing a money management plan. The paradox of this is that until you develop your money management skills and consistently utilize them on every single trade you execute, you will never be a consistently profitable trader.
I want to give you a professional perspective on money management and dispel some common myths floating around the trading world regarding the concept of money management. We hear many different ideas about risk control and profit taking from various sources, much of this information is conflicting and so it is not surprising that many traders get confused and just give up on implementing an effective forex money management plan, which of course ultimately leads to their demise. I have been successfully trading the financial markets for nearly a decade and I have mastered the skill of risk reward and how to effectively utilize it to grow small sums of money into larger sums of money relatively quickly.
Money Management Myths:
Myth 1: Traders should focus on pips.
You may have heard that you should concentrate on pips gained or lost instead of dollars gained or lost. The rationale behind this money management myth is that if you concentrate on pips instead of dollar you will somehow not become emotional about your trading because you will not be thinking about your trading account in monetary terms but rather as game of points. If this doesn’t sound ridiculous to you, it should. The whole point of trading and investing is to make money and you need to be consciously aware of how much money you have at risk on each and every trade so that the reality of the situation is effectively conveyed. Do you think business owners treat their quarterly profit and loss statements as a game of points that is somehow detached from the reality of making or losing real money? Of course not, when you think about it these terms it seems silly to treat your trading activities like a game. Trading should be treated as a business, because that’s what it is, if you want to be consistently profitable you need to treat each trade as a business transaction. Just as any business transaction has the possibility of risk and of reward, so does every trade you execute. The bottom line is that thinking about your trades in terms of pips and not dollars will effectively make trading seem less real and thus open the door for you treat it less seriously than you otherwise would.
From a Mathematical standpoint, thinking of trading in terms of “how many pips you lose or gain” is completely irrelevant. The problem is that each trader will trade a different position size, thus, we must define risk in terms of “Ddollars at risk or dollars gained”. Just because you risk a large amount of pips, does not mean you are risking a large amount of your capital, such is the case that if you have a tight stop this does not mean your risking a small amount of capital.
Myth 2: Risking 1% or 2% on every trade is a good way to grow your account
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This is one of the more common money management myths that you are likely to have heard. While it sounds good in theory, the reality is that the majority if retail forex traders are starting with a trading account that has $5,000 in it or less. So to believe that you will grow your account effectively and relatively quickly by risking 1% or 2% per trade is just silly. Say you lose 5 trades in a row, if you were risking 2% your account is now down to $4,519.60, now you are still risking 2% per trade, but that same 2% is now a smaller position size than it was when your account was at $5,000.
Thus, in the % risk model, as you lose trades you automatically reduce your position size. Which is not always the best course of action. There’s psychological evidence that suggests it’s human nature to become more risk averse after a series of losing trades and less risk averse after a series of winning trades, but that doesn’t mean the risk of any one trade becomes more or less simply because you lost or won on your previous trade. As we can see in my article on randomly distributed trading results, your previous trade’s results don’t mean anything for the outcome of your next trade.
What ends up happening when traders use the % risk model is that they start off good, they risk 1 or 2% on their first few trades, and maybe they even win them all. But once they begin to hit a string of losers, they realize that all of their gains have been wiped out and it is going to take them quite a long time just to make back the money they have lost. They then proceed to OVER-TRADE and take less than quality setups because they now realize how long it will take them just to get back to break even if they only risk 1% to 2% per trade.
So, while this method of money management will allow you to risk small amounts on each trade, and therefore theoretically limit your emotional trading mistakes, most people simply do not have the patience to risk 1 or 2% per trade on their relatively small trading accounts, it will eventually lead to over-trading which is about the worst thing you can do for your bottom line. It is also a difficult task to recover from a drawn down period. Remember, once you drawn down, using a 2 % per trade method, your risk each trade will be smaller, there fore, your rate of recovery on profits is slower and hinders the traders effort.
The Most important fact is this.. if you start with $10,000 , and drawn down to $5,000, using a fixed % method, it will take you “much longer” to recover because you started out risking 2% per trade which was $200, but at the $5,000 draw-down level, your only risking $100 per trade, so even if you have a good winning streak, your capital is recovering at “half the rate” it would using “fixed $ per trade risk.
Myth 3: Wider stops risk more money than smaller stops
Many traders erroneously believe that if they put a wider stop loss on their trade they will necessarily increase their risk. Similarly, many traders believe that by using a smaller stop loss they will necessarily decrease the risk on the trade. Traders that are holding these false beliefs are doing so because they do not understand the concept of Forex position sizing.
Position sizing is the concept of adjusting your position size or the number of lots you are trading, to meet your desired stop loss placement and risk size. For example, say you risk $200 per trade, with a 100 pip stop loss you would trade 2 mini-lots: $2 per pip x 100 pips = $200.
Now let’s you want to trade a pin bar forex strategy but the tail is exceptionally long but you would still like to place your stop above the high of the tail even though it will mean you have a 200 pip stop loss. You can still risk the same $200 on this trade, you just need to adjust your position size down to meet this wider stop loss, and you would adjust the position down to 1 mini-lot rather than 2. This means you can risk the same amount on every trade simply by adjusting your position size up or down to meet your desired stop loss width.
Let’s now look at an example of what can happen if you don’t practice position sizing effectively by failing to decrease the number of lots you are trading while increasing stop loss distance.
Example: Two traders risk the same amount of lots on the same trade setup. Forex Trader A risks 5 lots and has a stop loss of 50 pips, Trader B also risks 5 lots but has a stop loss of 200 pips because he or she believes there is an almost 100% chance that the trade will not go against him or her by 200 pips. The fault with this logic is that typically if a trade begins to go against you with increasing momentum, there theoretically is no limit to when it may stop. And we all know how strong the trends can be in the forex market. Trader A has gotten stopped out with his or her pre-determined risk amount of 5 lots x 50 pips which is a loss of $250. Trader B also got stopped out but his or her loss was much larger because they erroneously hoped that the trade would turn around before moving 200 pips against them. Trader B thus losses 5 lots x 200 pips, but their loss is now a whopping $1,000 instead of the $250 it could have been.
We can see from this example why the belief that just widening your stop loss on a trade is not an effective way to increase your trading account value, in fact it is just the opposite; a good way to quickly decrease your trading account value. The fundamental problem that afflicts traders who harbor this believe is a lack of understanding of the power of risk to reward and position sizing.
The Power of Risk to Reward
Professional traders like me and many others concentrate on risk to reward ratios, and not so much on over analyzing the markets or having unrealistically wide profit targets. This is because professional traders understand that trading is a game of probabilities and capital management. It begins with having a definable market edge, or a trading method that is proven to be at least slightly better than random at determining market direction. This edge for me has been price action analysis. The price action trading strategies that I teach and use can have an accuracy rate of upwards of 70-80% if they are used wisely and at the appropriate times.
The power of risk to reward comes in with its ability to effectively and consistently build trading accounts. We all hear the old axioms like “let your profits run” and “cut your losses early”, while these are well and fine, they don’t really provide any useful information for new traders to implement. The bottom line is that if you are trading with anything less than about $25,000, you are going to have to take profits at pre-determined intervals if you want to keep your sanity and your trading account growing. Entering trades with open profit targets typically doesn’t work for smaller traders because they end up never taking the profits until the market comes swinging back against them dramatically. (I think this is very important, go back an re read that last sentence)
If you know your strike rate is between 40-50% than you can consistently make money in the market by implementing simple risk to reward ratios. By learning to use well-defined price action setups to enter your trades you should able to win a higher percentage of your trades, assuming you TAKE profits.
Let’s Compare 2 Examples – One Trader Using the 2 % Rule, and one Trader using Fixed $ Amount.
Example 1 – -you have a risk to reward ratio of 1:3 on every trade you take. This means you will make 3 times your risk on every trade that hits your target, if you win on only 50% of your trades, you will still make money:
Let’s say your trading account value is $5,000 and you risk $200 per trade.
You lose your 1st trade = $5,000-$200 = $4,800,
You lose your 2nd trade = $4,800-$200 = $4,600,
You win your 3rd trade = $4,600+$600 = $5,200
You win your 4th trade = $5,200+$600 = $5,800
From this example we can see that even losing 2 out of every 4 trades you can still make very decent profits by effectively utilizing the power of risk to reward ratios. For comparison purposes, let’s look at this same example using the 2% per trade risk model:
Example 2 – Once again, your trading account value is $5,000 but you are now risking 4% per trade (so that both examples start out with a risk of $200 per trade) : Remember, you have a risk to reward ratio of 1:3 on every trade you take. This means you will make 3 times your risk on every trade that hits your target, if you win on only 50% of your trades, you will still make money:
You lose your 1st trade = $5,000 – $200 = $4800
You lose your 2nd trade = $4800 – $192 = $4608
You win your 3rd trade = $4608 + $552 = $5160
You win your 4th trade = $5160 + $619 = $5780
Now we can see why risking 4% (or 2% etc) of your account on each trade is not as efficient as the trader using the fixed $ amount. Important to note that after 4 trades, risking the same dollar amount per trade and effectively utilizing a risk to reward ratio of 1:3, using fixed $ risk per trade, the first traders account is now up by $800 versus $780 on the %4 risk account.
Now, If the trader using % risk rule had a draw down period and lost 50% of their account, they effectively have to make back 100% of their capital to be back at break even, now, this may also be so for the trader using the fixed $ risk method, but which trader do you think has the best chance of recovering? Seriously, it could take a very long time to recover from a drawn down using the % risk method. Sure, some will argue that you can drawn down heavier and its more risky to use the fixed $ method, but we are talking about real world trading here, I need to use a method that gives me a chance to recover from losses, not just protect me from losses. With a good trading method and experience, you can use the fixed $ method, which is why I wanted to open your eyes to it.
The power of the money management techniques discussed in this article lies in their ability to consistently and efficiently grow your trading account. There are some underlying assumptions with these recommendations however, mainly that you are trading with money you have no other need for, meaning your life will not be directly impacted if you do lose it all. You also must keep in mind that the whole idea of risk to reward strategies revolves around having an effective edge in the market and knowing when that edge is present and how to use it, you can learn this from my price action forex trading course.
While I do not recommend traders use a set risk percentage per trade, I do recommend you risk an amount you are comfortable with; if your risk is keeping you up at night than it is probably too much. If you have $10,000 you may risk something like $200 or $300 per trade.. as a set amount, or whatever your are comfortable with, it may be a lot less, but it will be constant. Also remember, Professional traders have learned to judge their setups based on the quality of the setup, otherwise known as discretion. This comes through screen time and practice, as such; you should develop your skills on a demo account before switching to real money. The money management strategy discussed in this article provides a realistic way to effectively grow your account without evoking the feeling of needing to over-trade which so often happens to traders who practice the % risk method of forex money management. Learn to use my price action strategies with the power of risk to reward ratios and your trading results will begin to turn around.
The Risk of Hedging Strategies On Forex And How To Overcome It
The hedging strategy hailed by many people was also a big risk. What is the risk of hedging strategy? How to solve it?
As ever discussed in Hedging Strategy Can be fruitful Profit Trading, hedging is divided into 2 types of planned and unplanned hedging. Generally, planned hedging is mostly done by professional traders who have been well aware of the market situation and conditions. While unplanned hedging is more done by newbie.
In this article will be a little more about the risks of unplanned hedging strategies, errors in removing hedging positions, and how to overcome them.
Double spread, Double Commission, Double Stress!
To perform a hedging strategy, you are required to open Buy and Sell positions in one pair simultaneously or with a relatively short time. Most will argue, with this you will not get a loss and just waiting to open when hedging. However, did you know that opening a position simultaneously on one pair is an impossible thing? Do not believe? Please try it yourself. In a lonely market condition, Bid and Ask price difference can be 1 to 10 points adrift. What about the crowded market or its volatility is rising? Of course more. This is not included if you are using a pending order or EA.
The point is, you have a loss when deciding to do a hedging strategy. A position that opens with such a relatively short period of time will never make a profit if it is closed simultaneously! Oh, wait a minute, why can this happen? The answer is actually simple: spread. Spread makes your order will never be in the same place.
ASK = The price that is executed when buying
ASK -> Profit is calculated from the BID value
BID = Price that is executed when selling
BID -> Profit is calculated from the ASK value
Spread = ASK – BID
Check out the picture above carefully, and look at it, or please try it yourself on your Metatrader. Perform hedging and your position will automatically loss to wherever the price will go. But wait, there’s something else. If you use an ECN broker, then the commission will also be charged in both positions. While over commission later is a very avoidable hedge fund with funds hundreds of thousands to millions of dollars. I have not included a swap fee yet. Considering most of you would already have a swap-free account, would not you?
The high cost resulting from spreads and commissions alone is already a big loss for you. This has not been added with anxiety, stress, fear because the position is still locked for days. Double spread, double commission, double stress!
Trapped In Endless Hedging
Already here do not tremble first, this is just the beginning. Ever seen Inception? In the film, Leonardo De Caprio is dreaming that he is dreaming in his dream. It can also be one of the risks of hedging strategies. You can be trapped in hedging hedging in a hedging position. This condition can also be referred to as Endless Hedging.
Most newbie traders learn the hedging strategies of some irresponsible people. These are usually people who claim to be market financial advisors, professional traders, or even hedge fund managers. With the lure of losses will not increase, the individual even asks beginner traders to increase his hedging position. Not infrequently you will be asked to increase the number of transactions in each hedging, so the trading strategy then changed to Martingale.
Trapped In Endless Hedging
Look at the picture above. This strategy is slightly different from the hedging strategy above. In this hedging strategy, you do not need to execute Buy and Sell in the near future; simply by putting a pending order at levels with a certain distance. This hedging strategy has been studied and practiced by the author several years ago. For the type and setting lotnya can vary and vary.
The hedging strategy of this model begins with a sense of uncertainty about current trends. Thus, the Pending Order is placed at levels that are potentially the beginning of the trend. The first trap is first installed with lot 1. When the price keeps spinning in the same place until the eighth Pending Order is touched, how to open a proper hedging?
Most newbie traders with low level of market knowledge will feel overwhelming with this situation. Uncertainty about this position can make you hesitate, even wrong in making decisions. This is because there are so many uncertainties that can happen. What if the price returns once we open the hedging? Or, what happens when the price has started a trend, while we are late opening the hedging?
The worst possibility is the price will continue to pace around that level, and our position will be locked in a long time. Not only that, you can also get Margin Call or even Stop Out when the hedging position is not open yet.
Wrong Open Hedging
Starting nauseous and dizzy? Stuck in endless hedging is not the culmination of all the risks that can happen when you do hedging. The biggest risk of course there is when you are wrong in the process of opening hedging. There are basically 3 possibilities that can occur after you release the hedging: gain, loss, or even break. This subject, here are some simulations that may occur:
1) False Determining Timing
In removing the hedging position, timing is the most important element. Unfortunately, timing is also the most common mistake in opening hedging. Generally, timing errors occur because a trader panics when the price suddenly moves against his position. This panic can also be continued until the time to remove the hedging position.
If hedging is done when the timing is fitted, at least the profit and loss will breakeven or breakeven.
2) Wrong Opening Position
In addition to timing, wrong release position is also a frequent mistake by traders. Most traders in Indonesia in particular, do not understand how to remove his hedging. They only have knowledge that hedging can lock the loss they are experiencing at that time. This lack of knowledge is even accompanied by a sense of laziness to learn. Often, the positional errors arise because of the Fund Manager’s suggestions.
Both position and timing are equally important. Although the position is released right direction, but if the timing is less appropriate release, losses may become even more swollen to cause Margin Call and Stop Out.
How to Overcome the Risk of Hedging Strategy
Do you still survive reading this article? If so, your desire and effort to learn and continue to grow deserves thumbs up. In this final section, we will discuss how to solve the risk of hedging strategy. A simple solution to this is actually only one: never do hedging at all! The ribetnya solution, let’s discuss some other possibilities that you may apply or at least learn.
1. Do not Do Hedging
Still remember some of the risks of hedging strategies above? If you are afraid of experiencing these things, you should cultivate in your mind, NEVER PREPARE HEDGING STRATEGIES! How often do you see the professional traders around you being successful because of a hedging strategy? Honestly, the author has never met a trader like that. However, the assumption may be because the author’s experience is still short in the world of trading. Make trading like a trading business. If you can maximize it, only with the average moving a lot has become a millionaire. The hedging strategy that is dizzying and triggering anxiety is unnecessary.
2. Take Advantage When Opening Hedging
If you remain insistent or fail to hold your hand itch to open a hedging position, then your position should end in profit. Treat hedging strategies like normal trading strategies with defeat limits, profit targets, etc. After all, what’s the point of trading if in the end you do not get a profit? Try reading this simple hedging strategy article if you have no idea about hedging that could be a lucrative thing. In addition, there are many other strategies that can be used and put together with hedging.
3. Learning, Learning, Learning
Has it started bright and bright mind? It is not worth your time to read an article about the risks of hedging strategies is not it? Your curiosity to benefit from current hedging strategies has increased, right? At the end of this article, I will include some references and strategies you can use along with hedging.
Always remember, there is no Master in the world of forex trading. Man continues to evolve, so does the psychology of the market. If you are reluctant to continue growing, then of course you will be left behind by others. So focus your mind right now to keep learning, learning, and learning. If you are confused from where, maybe you should start back from basic. What is the forex trend, perhaps? About trader psychology, maybe?
You should read carefully this last point. This last point can be a cure from a variety of trading diseases. If you understand this point, even using the most absurd trading strategy though, you will never get MC or SO.
Money Management Is The King
Money Management is the king. For this you may be able to read more in a good money management article. But briefly and succinctly, trading is business. So if this business may have spent a lot of your money, not because you can not trade or mentally you are weak, but because you can not manage and control the running of finances in your trading account.
Try to ask yourself, how can a company achieve a very high profit with various costs to be incurred? Because of its financial arrangement. A company knows how to manage the entry of the money path. Some ways may be to stop some products that do not get a satisfactory market response, do market mapping, or hire a qualified accountant and financial advisor. Everything is done so that the flow of finance in the company can run well, or you can say profitable.
Now let’s use the same analogy on trading. Read again the above paragraph, just replace the company with forex trading. Have you set up your funds in and out? Have you studied the market you are about to enter? Have you closed all positions that have lost or bad response from the market? Have you hired a mentor who can teach you? If not, it may be time for you to improve.
How was your journey along this article? enough tense? Is it worth the time you spent reading this article? In closing, I will remind again as the author, that hedging is a trading strategy with a very high level of difficulty. The process is not good for your learning process or your psychological condition, so it might be better if you cut loss and acknowledge the loss.
Please be careful in doing hedging and locking. If you do not really understand how to make decisions in the hedging process, or just have heard that hedging can lock your loss, we recommend STOP! Never do hedging again. But if you want to learn more, here are some strategies that can be used with the application of hedging.
The strategies included here will be further studied, backed up or forward tested first, especially if you use them to seek profit in hedging. These strategies are chosen because they involve mostly ranging conditions in the market. Here are the types of strategies:
- Trading with rounding bottom pattern.
- Trading with bbma.
- Trading with bollinger bands.
- Trading with double top and double bottom pattern.
Money Management in Forex: More Than Just Trading
Introduction: Money Management in Forex
In this article, you’re going to learn everything you need to know about money management in forex.
We have discussed all the angles on and the importance of Stop Losses in the articles called “The Ultimate Guide On Stop Losses”, click here for Part 1 and click here for Part 2. If you have not read that guide, make sure to take a look!
Of course, the stop loss is just a part of the entire equation in our world of Forex trading. Here, we are going to continue with this material, but we are going to look at a broader topic: Money Management (MM). MM is, of course, a vital topic, and is of equal importance as Risk Management, Trading Strategies, Trading Psychology, and Trade Management.
What is Money Management?
Let us start with the question: what is basic Money Management? The core goal of successful money management is maximizing every winning trades and minimizing losses. A master of money management is a master Forex trader. Money management is a method to deal with the issue of how much risk should the decision-maker/trader takes in situations where uncertainty is present.
You might ask yourself, isn’t basic money management the same as risk management?
Risk management, in fact, is your choice of how much risk you want to place on a trade.
You are always in control of how much risk you place on a trade: whether that it is 1% or $100, but I would recommend using a standard % risk (not $) of your designated trading capital. Every trader’s first goal is to preserve the trading capital, which is achieved by being very disciplined in the field of risk management.
In Money Management every trader is actually looking at the reward to risk ratio, or R: R ratio in short. Money management calculates the balance between the risk and the reward of the trade. In Money Management, the following definitions are vital:
- The risk is the stop loss size (discussed in previous articles).
- The reward is the profit potential (take profit minus entry).
How many pips a Forex trader has earned is really not of much value, unless the pips risk is mentioned as well. Anyhow, it would be better to focus on the Rate of Return % and $/money earned. This is what all businesses do and all of us should treat trading as a business.
Reward to Risk Ratio
The ratio between the two is crucial. A trader that targets a quarter of the risk has just won one “battle” but has just lost the “war”. In trading terminology, this means that a trader might have won a trade, but ultimately the win means nothing and that Money Management has set them up for failure. Why?
For a trader to become long-term profitable with a 0.25 reward to risk ratio, the trader would need to win 4 trades to compensate 1 loss. With this equation, the trader has not made any profit. Of course this R: R makes no sense: a trader needs to get above the 80% win % to achieve profit. Not an easy feat.
With a 1:1 Reward to risk the trader only needs to win 51% and more to be profitable. In practice, it would be better to have 60% wins or more. With a 2:1 R:R a trader only needs 35% win rate.
Here are all of the mathematical statistics to make sure you are a profitable Forex trader:
- With a 0.5:1 R:R… You need a minimum of 67%+ wins.
- With 1:1 R:R… You need a minimum of 55%+ wins.
- With 2:1 R:R… You need a minimum of 35%+ wins.
- With 3:1 R:R… You need a minimum of 28%+ wins.
- With 4:1 R:R… You need a minimum of 21%+ wins.
- With 5:1 R:R… You need a minimum of 17%+ wins.
- With 10:1 R:R… You need a minimum of 11%+ wins.
- With 20:1 R:R… You need a minimum of 6%+ wins.
Here is a fast way of calculating if you have correct and rational control over your capital which provides positive mathematical expectancy:
Formula: Win % x Take profit size – Loss % x Stop Loss size
Win % for example 30% * take profit pips 55 – loss % for example 70% * 20p = 2.5 (positive = long-term win).
The smaller the stop loss, the better the R:R ratio when using the same target OR the better the odds of win % when using the same R:R.
Question: What Reward to Risk Ratio Do I Target?
I would like to ask you for some feedback. I think the best way to learn is by sharing the experience with each other. What kind of Reward to Risk ratio do you usually target? Please place a number and we will know it’s the ratio! For example, if you usually target a 3 reward for 1 risk, then please write down a 3. Thanks so much!
By the way, here is a great Forex educational video where you will see how powerful the concept of a 2:1 R:R really is. Make sure to take some time to read this great Forex training on the “risk to reward ratio.”
R:R using Fibs and Elliott Wave
Minimize the risk of Fib trading and decrease the potential stop loss size by splitting your trading into multiple parts. If a Forex trader decides to put their entire risk of the trade (for example 1%) on the 382 Fib, then they have no opportunity to add a trade even if the currency would retrace deeper to the 618 or even the 786 Fib.
- Splitting the trade into 2 or 3 parts allows for flexibility and psychological ease as well: a trader does not have the feeling that they will miss a trade with tying themselves down to a single entry point.
- Splitting the risk into 3 positions would mean that the trader choices to split the chosen risk of 1% into 3 parts. The risk can be evenly divided among all 3 parts (3×33%) or more weighted to one Fib level (for example 20%-30%-50%).
With a 1% risk total, this means either 3 trades with 0.33% or 3 trades with 0.2%, 0.3%, and 0.5%. This is called cost averaging. Businesses used it often: it makes their inventory cheaper. For us Forex traders, it makes the average stop-loss smaller and that is great for our R:R.
Forex traders can do the same for Fib targets. By splitting the trader with different take profit targets, they can optimize the profit average of all positions and the entire trade.
The Elliott Wave can be used to decide which Fibs and with which division % the trade is taken. For example, for a wave 2 the trader can choose to put the risk on the 500, 618 and 786 Fib with the following division of the risk: 25% on 500 fib, 35% on 618 fib, and 40% on 786 Fib. For a wave 4 the division would be skewed higher: maybe 50% on the 382 Fib, 25% on the 500 fib and 25% on the breakout.
The EW can also be used for Fib targets. A trader should aim for higher targets if a wave 3 is expected and for closer targets if a wave 5 is expected.
How To Calculate Position Sizes:
Position sizing is important because it allows the trader to adjust the size of the trade according to the market conditions. If a trader takes a fixed position size of 1 mini for example, the loss can vary widely depending on the size of the stop loss. With position sizing, that can never happen and a trader is always in control of their risk!
With position sizing, the stop loss size is not important for risk management. No matter what the stop loss size is, Forex traders always choose the risk percentage level. That said, the stop loss size is important for money management. The stop loss size is an integral part of the Reward to Risk ratio.
- Here is how any trader can calculate position sizing’:
Determine the desired risk level (risk management) à a trader determines the risk level of that particular trading strategy, trading week, trading day, market structure, and that particular trade;
- The trader needs to determine the best stop loss placement: not too close to market action, but not needlessly distant as well. Please read this article about stop losses to learn about the best placements.
- The trader needs to choose an achievable and realistic take profit target. Because we already did an article on stop losses, I was thinking of doing one on take profits next week. It depends if there is any interest. Would you like an article on taking profits?
- The R:R expectancy ratio should provide a positive mathematical expectation.
- Deposit = 5000 EUR
- Risk = 1% from Deposit = 50 EUR
- Currency pair = EUR/USD
- SL = 30p = 300 USD on a standard lot basis
- Size to open in order not to risk more than 1% = Risk/SL = 50/300 = 0.16 lots
How Much Leverage Do I Use?:
Be careful with the leverage you use. A good rule of thumb is to use for example 5:1 leverage. That way a Forex trader is not over-trading. For example, if your account balance is 5,000 USD, then your total is the capital of $5000 multiplied by your leverage of 5, which equals $25,000. A mini lot is $10,000, so that would be 2.5 minis. Use this formula to calculate how much risk you are taking: (SL times/multiplied by Leverage)/100 %. For example if the stop is 30 pips: (30 x 5) / 100 = 1,5 % of risk.
Reinvesting Trading Capital:
Regarding the trading capital, a trader has several options.
- Reinvest the profits back into the trading capital. This way the trading capital gets larger and a percentage risk of the capital is realizing a higher return in USD (same percentage risk though);
- Withdraw all profits. This way the trading capital remains the same;
- Semi-flexible approach with some withdrawals and some reinvestment.
I think that option 3 is the best money management approach. Growing your account is a great thing, but you want to withdraw some money once in a while so that you still realize that the numbers are your account are still real and not fake! Then again, withdrawing everything will take away the advantage of compounding your profit. So option 3 is the best value. You can also read about budgeting in forex for better trading.
Pro Tip – Use a Stepped Approach:
What I approach for point 3 is a step approach. This is how it goes:
- Use the same current trading capital for your risk management until you have a drawdown of x % or a profit of x% (the numbers are your choice).
- Once you hit your drawdown maximum, you will use the new trading account balance as your trading capital.
- Once you hit your profit target, you will use the new trading account balance as your trading capital.
- If you hit your profit target, you can decide the division of withdrawal and add-on % of the profit. So you could choose to withdraw 50% of your profits and add 50% of profits to your trading capital. The new trading capital balance would be your old trading capital + 50% of the profits.Also, be sure to read banker’s way of trading in the Forex market.
Hedge With Multiple Trading Accounts:
Another part of your money management strategy is that you want to make sure that you are diversified. This is also known as a hedging strategy.
- Preferably you are only investing a part of your savings into the Forex trading capital and you have a decent percentage of your savings invested in other vehicles – if possible.
- You have multiple accounts with different goals. This is to spread the risk of having your trading capital on one account. The different accounts can also be used for different strategies and purposes: one could be for long-term trading, the other for intermediate.
- Keep part of your trading capital on your account. Even though you want to trade with a certain amount of money, there is nothing wrong with keeping a part of it on the bank account. I do not think that a trader needs to put all 100% on the trading account, but make sure a margin call is not needed if you opened a trade with 1 mini. Want to learn more about mini trading? Read the ultimate guide to trading emini futures here.
Thank you for reading!
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Forex Hedging: What is It and How Do You Use It?
Investors of all stripes use hedging as a strategy to protect one position from adverse price movements. Typically, hedging involves the opening of a second position that is likely to have a negative correlation with the primary asset being held, meaning that if the primary asset’s price makes an adverse movement, the second position will experience a complementary and opposite movement that offsets those losses.
In forex trading, investors can use a second pair as a hedge for an existing position they’re reluctant to close out. Although hedging reduces risk at the expense of profits, it can be a valuable tool to protect profits and stave off losses in forex trading.
Understanding the Basics of Forex Hedging
Forex hedging involves opening a position on a currency pair that counteracts possible movements in another currency pair. Assuming the sizes of these positions are the same, and that the price movements are inversely correlated, the price changes in these positions can cancel each other out while they’re both active.
Although this eliminates potential profits during this window, it also limits the risk of losses.
The simplest form of this is direct hedging, in which traders open a buy position and sell position on the same currency pair to preserve whatever profits they’ve made or prevent any further losses. Traders may take more complex approaches to hedging that leverage known correlations between two currency pairs.
How a Forex Hedge Works
The process of opening a forex hedge is simple. It starts with an existing open position—typically a long position—in which your initial trade is anticipating a move in a certain direction. A hedge is created by opening a position that runs counter to your expected movement of the currency pair, allowing you to maintain an open position on the original trade without incurring losses if the price movement goes against your expectations.
Oftentimes, this hedge is used to preserve earnings you’ve already made. The NOK/JPY chart below demonstrates a situation in which a trader might want to hedge. If, for example, they opened a long position close to the low point of that chart and capitalized on the significant gains that developed in the subsequent days, the trader may choose to open a short position to hedge against any potential losses:
Although the trader could also simply close their position and cash out their earnings, they may be interested in maintaining that open position to see how the chart patterns and technical indicators evolve over time.
In this case, the hedge can be used to neutralize potential profits or losses as the trader maintains that position and gathers more information. Even if the price plummets, they’ll be able to cash out all of the earnings they generated from that initial upswing.
Creating Complex Hedges in Forex
Because complex hedges aren’t direct hedges, they require a little more trading experience to effectively execute them. One approach is opening positions in two currency pairs whose price movements tend to be correlated.
Traders can use a correlation matrix to identify forex pairs that have a strong negative correlation, meaning that when a pair goes up in price, the other goes down.
The USD/CHF and EUR/USD combination, for example, is a great option for hedging because of its strong negative correlation. By opening a buy position on USD/CHF and a short on EUR/USD, traders can hedge their positions on USD to minimize their trading risk.
Trading with forex options also creates hedging opportunities that can be effective when utilized in specific circumstances. It takes an experienced trader to be able to identify these small windows of opportunity where complex hedges can help maximize profits while minimizing risk.
When to Consider Hedging
Hedges are useful whenever you’re looking to maintain an open position on a pairing while offsetting some of your risk in that situation.
A short-term hedge can be a great way to protect profits when you’re unsure of certain factors that could cause volatile price movements. This uncertainty can range from a suspicion that an asset has been overbought to concerns that political or economic instability could cause certain forex pairs to plummet in value—particularly when you’ve opened a long position on those pairs.
In the USD/JPY chart shown below, a period of consolidation is creating breakout potential that could go in either direction. If you already have an open position in this currency pair and are hoping that the price decline breaks through the resistance line, you might consider hedging with another position, targeting a rebound from the trend line back up toward previous highs:
If you do open this hedge and the price breaks through the trend line, you can always close your second position and continue reaping the profits of your successful short. But if you’re wrong and the trend reverses course, you can close both positions and still cash out your earnings from the previous price change.
Traders often use hedges to protect against the short-term volatility of economic news releases or market gaps over weekends. Traders should keep in mind that as hedging reduces trading risk, it also lowers potential profits.
Because of the low returns created by hedging, this strategy works best for traders who are working the forex market full-time or have an account that is large enough to generate big monetary gains through limited-percentage profits.
Exiting a Hedge
When you’re exiting a direct or complex hedge and keeping your initial position open, you need to close out only the second position. When you’re closing out both sides of a hedge, though, you’ll want to close these positions simultaneously, to avoid the potential losses that can come if there is a gap.
It’s important to keep track of your hedged positions so that you’re able to close out the right positions, at the right time, to complete the execution of this strategy. Overlooking one open position in the process can derail your entire hedging strategy—and potentially hit your trading account with steep losses.
Always Be Aware of Risks When Hedging
Although forex hedging is typically used to limit risk for traders, poor execution of this strategy can be disastrous for your trading account.
Due to the complexity of hedging in forex, traders can never be fully assured that their hedge will counteract any possible losses. Even with a well-designed hedge, it’s possible for both sides to generate a loss, even for experienced traders. Factors such as commissions and swaps should also be carefully considered.
Traders should not engage in complex hedging strategies until they have a strong understanding of market swings and how to time trades to capitalize on price volatility. Poor timing and complex pairing decisions could lead to rapid losses within a short period of time.
Experienced traders can use their knowledge of market swings and the factors affecting these price movements, as well as a strong familiarity with the forex correlation matrix, to protect their profits and continue creating revenue through the use of timely forex hedges.
The information provided herein is for general informational and educational purposes only. It is not intended and should not be construed to constitute advice. If such information is acted upon by you then this should be solely at your discretion and Valutrades will not be held accountable in any way.
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