Before start trading Forex, a trader should develop these money management rules based on his/her trading strategies and style of trading.
Here are some important money management strategies to follow.
- The first rule to set and follow is the position sizing rule. You should not put all of your invested money in one trade. This carries a high risk and less chance to win. To avoid this high risk a trader should divide his total investment into small equal parts.
This way you can reduce your risk, increase your chance of profit and diversify your investment in various pairs. In the Forex market, a trader should not divide his initial investment less than 4 parts.
You can choose this number of parts based on the number of currency pairs you are trading. For example, if you trade in 5 pairs then you should divide your initial investment into 5 equal parts.
- The second step of money management rule is to set a stop loss to minimize your risk. If you do not limit your losses, then it can become gigantic.
To avoid massive losses you must have a stop loss strategy to reduce the risk of your losing positions. There are different types of methods to place a stop loss. You can place a fixed stop such as 20 pips stop loss in each trade.
You can also use logical stops or indicator based stops. Logical stops are placed at support-resistance and swing points. Indicator based stops are taken when indicator generates an exit signal.
- The third step you should take is to set a risk to reward ratio to define your exit strategy. This depends on your trading strategy and trading styles.
If your trading strategy provides high winning ratio (such as 70% winning ratio) then you can use smaller risk to reward ratio such as 1:1. On the other hand, if your trading strategy provides a low winning ratio (such as 40% winning trades) then you must have a high risk to reward ratio such as 1:3.
This way you should determine an R:R first, then place the exit order following that ratio. If your R:R is 1:3 and your stop loss is 20 pips then your profit target would be 20 x 3 = 60 pips.
- There are some additional money management rules to follow in Forex trading.
Scaling in and scaling out are two additional rules you can add and follow with your money management strategy. Some traders enter a position with numerous small bets to reduce the risk, this is called scaling in.
On the other hand, scaling out means taking the partial exit. Scaling out is a process to sell out a small portion from the total holdings. Scaling in strategy reduce risk and scaling out helps traders to lock good profit.
Money management rules should be suitable with a trading strategy. So, before setting these rules, the trader should check his trading strategy and find suitable money management set ups.
Different trading strategies require different money management setup. Stop loss, take profit and risk to reward ratio should be appropriate for a trading strategy you use in Forex trading.