Many currency traders find it hard to follow simple risk management rules. Many times, they will turn winning positions into losing ones. They will be surprised to find solid trading strategies result in losses instead of profit.
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The most likely main cause is that many currency traders commit the same common mistakes. However, the good news is that these mistakes while they can be emotionally and psychologically challenging, can be solved.
Risk-reward ratio is very important for you to know and understand. As a trader you should calculate a risk-reward ratio for every trade that you make. In more simple words, you should have an idea of how much you are willing to lose if the trade goes against you. You should also know how much you are expecting to make in a trade. A general rule of thumb that you should apply is that your risk-reward ratio should not be less than 1/2. With a solid risk-reward ratio, you can eliminate a trade that is not worth the risk by not entering it.
There are two ways to place the stop loss order.
1) Initially place the stop loss at a reasonable level.
2) Trail the stop meaning move it forward towards profitability as the trade progresses.
There are two recommended ways of placing the stop loss order. One involves placing the stop loss order 10 pips below the two days low of the currency pair. For example, if the EUR/USD recent low was 1.1300 and the previous day low was 1.1200, then place the stop loss at 1.1190, 10 pips below the two day low if you want to go long.
Failure in investing comes in two forms; Failure to maintain your principle and failure to effectively grow your principle. If you want to become a successful trader, than you need to learn how to grow your principle in the long term.
You should know before each trade how much is truly at risk in a single trade? Many traders misunderstand this and don't know their risk. Suppose you have a $10,000 account and you buy one lot of EUR/USD. Your Forex broker will set aside $1,000 in your account as a margin, so how much of your money is at risk? Many would say only $1000 but they are wrong. You have $9,000 to trade, $1000 was for margin. So your risk is $9,000 and you could lose up to this much before you receive a margin call from your broker.
No matter where you set the stop loss, the amount of money that you set aside with your broker as margin does not tell you anything about the risk unless you plan to get a margin call. Understanding these common money management pitfalls will help you a lot. Unless, you do not develop your own money management rules, you will most likely fall into one or more of these pitfalls.
Investors who enjoy the greatest amount of success in their trading are those who have clearly established money management rules that govern their trading.
Calculating position size under the different money management systems is a tricky stuff. You just need to understand the concept. Trading software packages often include money management calculators with them. Let's discuss some of the different systems. There are more but these are some of the most commonly used by traders. Another thing that you need to keep in mind is that stock trading may require a different money management style as compared to futures trading or forex trading. So you need to understand the concept behind these different money management styles as a trader.
Fixed Ratio System
The second most basic system is the Fixed Ratio System. It is widely used by options and futures traders. If you want to trade options and futures, just type the name of this money management system on any search engine. You will find the formula.
Martingale
Now, a money management system that had its origins in gambling and betting but is used by many traders is the Martingale Money Management System. Many traders love to use this system when they start losing. There are many trading systems that use the martingale strategy to recover from a loss. There are a number of forex robots or what you call expert advisors that use this strategy to recover loss. What is this strategy then? Suppose you are trading with $2,000. If you make a winning trade, good enough, you again trade with $2,000. But suppose you lose. In this case, you double your amount to $4,000. Suppose, you win, you will recover the loss on the first trade. But suppose, you lose again. So, you double this amount again to $8,000. You keep on doubling until you hit a winner. Pretty risky, huh!
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