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Forex Money Management (How to Go Bankrupt in One Day)

To stand any chance of surviving in the forex market, a good money management system (and the fortitude to follow it!) is absolutely essential. Due to the extreme leverage being employed, your account could go to zero very quickly (of course your broker will probably issue a margin call and close out your positions before that happens - this is why it is virtually impossible to go to zero balance, but why nitpick?).

From what I've read over the Internet, the pervailing wisdom appears to be that one should not risk more than 3% of the account value in a single trade. For example, in a $10,000 account, the max loss per trade would be $300, or 30 pips trading a standard lot. Whether or not this is sound advice is relative - the only thing for sure is that the 3% rule is completely arbitrary. I haven't seen any math to back up the idea that 3% will ensure you turn a profit. Personally, I think it is a good idea, simply because I am poor, and this rule has kept me from losing my shirt on any given trade. Ultimately it's up to each trader to decide the risk tolerance, but if you don't know then 3% is probably a good start. Notice that the suggestion is a max of 3%; 1% is probably a better choice in my opinion (but part of the fun of forex is making money fast...).

Another good suggestion is to quit trading when you're having a bad day. Now this seems excruciatingly obvious, but trader psychology suggests then when one is having a losing day, one is more inclined to continue trading, if only to 'get back to even'. Statistically that is not a tenable position - your expected return is going to be negative that day, unless you can hit a major win on a trade (and that is already going to be pushing three sigma so good luck with that). Remember - losing is an expected part of any trading strategy. If you are expecting to find the 100% accurate system, you will be hard pressed to find it. It may exist, but I wouldn't know.

A Note on Risk

An age old question that every trader asks at some point during a trade: "Where do I put my stop loss and take profit targets?" Like the money management above, I have found the pervailing wisdom to be quite arbitrary here as well. Some suggest a hard stop. Others advocate a stop be placed relative to some indicator (Fibonacci is quite popular). Personally, I try to keep my stop loss to around 20 pips. However, the size depends on the reason I want to take the trade (e.g., depends on the strategy or method I used to analyze the price action and decide on the trade). Have a look at the strategies pages for details on the stop loss levels.

A related question is where to have profit targets. Again, this is related to the system one uses, but I think at a minimum you need a 1:1 risk/reward ratio to make any sense (ideally 1:2 or lower). Some say ATR, others say a fixed target. Me, I think it depends on the style, the person, and the market. My guess is that the probability of success will fall as the profit target rises, so I wouldn't think anything more than 1:2 is advisable very often. In cases where I use a fixed profit target, I only use a couple pips more than the stop loss (e.g., if I have a 20 PIP stop the target is around 22 pips). That way at least the expected return will be positive if my win/loss ratio is half (of course 50/50 is acceptable but not so great in my opinion).

Another related question: does quitting while you're ahead make any sense? Well I don't know. Forex is a volatile game that's all about averages; thus I think it is worthwhile to let runners run. In other words, I wouldn't necessarily quit while I'm ahead, since you need make sure your averages hold up. Here's what I think. I think that I would be lucky to even be 50% right on all the trades. So, if I use a risk/reward of 1:1, then I will statistically break even over the long term, which is only slightly more fun that losing money. Thus, I need to let my runners run a little bit (or be lucky enough to have better than 50/50 win rate).

That's another question: Is it statistically possible for a trading system to be better than a coin flip? Well if you believe in technical analysis enough to be reading this, I would hope so. I think that it is indeed possible to be right 2/3 or 3/4 of the time on paper, but once emotions come into play, most traders will fail to reach that potential. I know for a fact that I personally have screwed up big winners by getting out too early. So, one can only dream to be completely unemotional when money is on the line. However, with enough practice maybe we all can aspire to be right on 100% of the winners (not to be confused with 100% success rate - only that if 10 of 18 are winners, then we have the will and strength to sit through all 10 winners and not bail early).

With that said, maybe a coin flip isn't such bad odds. Now you know why I think proper money management is so important.

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