You believe that your strategy is awesome, that your technical analysis is accurate and given the latest profitable trades you’ve had, you may even think that you’re being favored by the odds. Keep dreaming, my fellow Forex trader! The odds likely do not favor you, and if there is one thing to be sure about, it is the fact that sooner or later you will be on the wrong side of a trade. A few successful trades can boost your confidence tremendously and as a result you may invest incrementally more each time, but also increase your chances that a single disastrous trade drives you to a sudden Forex death.
As a Forex beginner, it took me only two weeks to lose about 75% of my initial investment. Unfortunately, I have learned what a “margin call” was prior to understanding what “risk management” was. It took me a much longer time and very hard work to recuperate that initial loss. The lesson I have learned is that you have to learn to be a smart loser. Risk management can make the difference between losing just a little bit when compared to losing much more, or possibly everything.
Most novice traders are hesitant of letting go of a few dollars when a trade starts going bad, deciding to rather wait for their trading pair to reverse course back into profit. This line of thinking is understandable, because every dollar that we have in our trading portfolio came from somewhere, had to be earned somehow, and because nobody can, or ever will be able to easily part ways with money.
On the other hand, however, think that you may indeed lose a few dollars to a bad trade, but you could get out in time to trade in the opposite direction if market conditions support that. The market will keep sliding, but this time around you will be on the winning side.
Managing Forex risk is by no means a tough job. There are just a few simple rules to follow, and if you religiously live by them, you will soon realize that these rules really make the difference between being a successful Forex trader and being an ex-trader who can only afford to play with demo accounts.
1) Do not enter a trade unless you feel confident about it. It is much easier to grab a bag of popcorn, sit back and watch how the market moves, than to enter a trade too early, too late, or in the wrong direction. Do your homework, analyze the market from all possible technical and fundamental sides and get a feel for it before you risk anything.
2) Invest only as much money as you can afford to lose. Sounds like a broken record, but there is always a possibility that the money you are investing will be gone before you know it. Especially with leveraged trading, you feel compelled to invest everything in your account in order to maximize your profit. But remember that the more you invest, the more you can win, but also the more you can lose. In my case, only when I am absolutely sure about the market, I invest a larger sum, but never more than 5% of my available margin.
3) All your trades must have a stop loss (SL). This setting puts a limit on how much you can lose and if and when that level is being reached, your trade is automatically closed. As dramatic as it may sound, you can win by closing a trade early at a loss, since you will still have all the money in your account that you would have lost if you had continued with a trade gone bad. My simple rule of thumb is using a 1:2 risk/reward ratio when determining where to set my stop loss. So if I am aiming for a 200 pip profit, I am setting my stop loss at 100 pips. Some traders choose more aggressive 1:3 or 1:4 ratios, but I came to realize that anything more than a 1:2 ratio increases the chances that the market will reverse before it hits the take profit (TP) level. I think 1:2 is conservative, but it is what works best for me.
4) Be a cold-blooded trader, because Forex is definitely not the place for emotions. If you just entered a trade and set a stop loss, and see that the market approaches your stop loss level, do not touch the stop loss. Don’t let your emotions get the best of you. The stop is there for a reason.. Also, if you just lost a trade, move on! Keep your cool, analyze what went wrong and why it went wrong. Everything happens for a reason and sooner or later you will find the reason why your trade went bad. Learn from it and use this experience for future trades.
Last, but not least, create your own set of risk management tools and rules. How much to invest/risk, where to set your stop loss and how aggressive you want to trade in general are your own decisions. Adapt your trading to your level of comfort. Experiment, learn, and convert bad experiences into useful knowledge. Just do not repeat the mistakes you have already made. Albert Einstein once defined insanity as doing something over and over again while expecting a different result.