Five Top Money Management Tips

Updated: April 25, 2016 at 11:19 AM

Trading the forex market without safeguards can be like skydiving without a parachute. Anyone serious enough about trading would do well to incorporate money management techniques to their trading plan to protect their portfolio.
Nearly all successful traders use a money management strategy along with their regular trading plan, and if you have ever experienced a severe drawdown on your account, you probably do too.
Basically, having safeguards in place to protect your account to remain in business is far better than the alternative. What follows are some general guidelines for money management which can be incorporated into a trading plan.

Tip #1: Only Trade With Risk Capital

Trading currencies involves taking substantial risks, no matter how you look at it. Because of the free-floating currency market, currency trading has considerably more in common to gambling than investing.
As a result, putting funds at risk which you cannot afford to lose should never even be considered by a responsible forex trader. This includes money needed for key housing expenses such as your mortgage or rent payment, or the weekly food allowance necessary for your or your family's sustenance.
In general, traders do better by only trading forex with funds known as risk capital. Such money has been specifically designated for trading because it is expendable and therefore not needed for the basic essentials of living.

Tip #2: Cut Losses Short, Let Profits Run On

These just have to be some of the most popular words of wisdom that Wall Street has ever passed on to its novice traders.
The basic idea behind this saying is that you should first endeavor to manage your risk by using stop losses in a disciplined way.
Secondly, you should also allow your profits to accumulate when you have a winning position. Traders often use trading stops for this purpose.
Furthermore, as a wise trader once said, "In trading, it's not what you make, profits take care of themselves; it's what you don't lose that really matters."

Tip #3: Avoid Using Too Much Leverage

Because of the nature of the forex market as a venue of exchange for currencies, initiating a forex position involves the equal value exchange of two currencies. This requires no money initially, in theory anyway, because it is not a purchase or sale of a commodity or stock, but instead represents a rate of exchange.
Most online forex brokers therefore offer their customers leverage ratios which can be as much as 500:1. This means that for every dollar you place up as collateral against potential losses, you can control $500. While this sort of leverage can be extremely profitable on a winning transaction, it can also deplete your account just as quickly, cleaning it out in just one sharp forex move. (In the U.S. the maximum leverage is 50:1 for majors and 20:1 for minors.)
Essentially, leverage must be only used if you keep the size of any potential losses firmly in mind. This way, your portfolio will not suffer severe, unplanned draw downs if you find yourself on the wrong side of the market, as almost all forex traders do at one time or another.

Tip #4: Avoid Taking Too Much Heat

The heat factor when trading consists of how comfortable you feel with the amount of risk you have assumed on any given position.
Essentially, if you cannot sleep at night because you find yourself worrying about your forex trading positions, then you will generally be taking on too much heat in your trading portfolio.
Heeding this tip involves only taking positions you feel comfortable with and keeping your trades to a manageable size in proportion to your overall account size.

Tip #5: Do Not Give in to Greed

Maybe "greed is good" as Gordon Gecko, the fictitious trader modeled after Ivan Boesky once maintained in the classic financial markets movie "Wall Street". Nevertheless, greed has been the downfall of many a successful trader.
In fact, greed leads to a number of risky trading errors. These include: overtrading, excessive risk taking and failing to take profits at appropriate levels.
One of the best ways to deal with greed when it inevitably arises when trading forex involves having appropriate safeguards against it built into your trading plan.

Use the above tips in Your Trading Plan

By trading objectively through having a sound trading plan and incorporating the wisdom contained in the above money management trading tips, you will be far more likely to be profitable in the long run than if you traded based on your emotions and without any plan at all.
Perhaps even more important is maintaining the discipline necessary to follow your plan once you have made it.
Read more on risk management principles for forex trading.
Read more on the risks with leverage.
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

Position Sizing Using the Risk Reward Ratio

Updated: April 25, 2016 at 11:21 AM

Position sizing involves making an objective decision about what positions to take when trading, and it makes up an important part of just about any sound money management strategy. As a result, it would be a good idea for forex traders to incorporate some form or position sizing methodology into their trade plans.
Furthermore, many successful traders routinely assess the risk reward ratio of a particular trade they are considering entering as part of their decision making process. Some of them even incorporate criteria based on risk reward ratios into their trading plan.
An additional application of risk reward ratios among forex traders is in performing position sizing. Such a technique usually increases the size of a position depending upon how successful the trade is anticipated to be.

Determining the Risk-Reward Ratio on a Trade

The basic idea involves quantifying the anticipated amount of risk or loss that the trade might result in and then comparing this to the trade's quantified potential returns. To perform a risk-reward ratio calculation in its most simple sense for a particular forex trade, you would just calculate the number of pips from your entry rate until your stop-loss level and compare the result to the number of pips until your projected take profit level.
In general, a risk-reward ratio of 1:2 means that you would risk one pip of loss to potentially earn 2 pips.
To provide a general guide, most successful traders will not enter a trade unless the risk they foresee for it is less than half of what their anticipated reward will be. This means they have a 1:2 minimum Risk/Reward Ratio criterion for any trades they will consider entering.
Basically, having your risk be less than your potential reward on prospective trades is one of the recipes for successful money management over the long term when trading forex.
Of course, once a trade is entered, any changes to the stop loss or take profit levels, perhaps using the technique of trailing stops will change the risk reward ratio of the position.

Using the Risk Reward Ratio

Traders often use risk reward ratio criteria to help them place stop loss orders and also when assessing how large a position to take. In addition to assessing the risk reward ratio the trader is willing to assume before any trade, they may also take into account important technical analysis factors like the presence of nearby support and resistance levels.
Most successful traders refuse to take on a position unless they can expect to at least make twice the original investment. This would be a minimum risk/reward ratio of 1:2, where they risk one unit to make two.
They can also take on larger trades when a higher probability of success is anticipated, perhaps using the risk reward ratio as a criterion for doing so.

Sizing Positions Based on the Risk/Reward Ratio Alone

Although simpler ways exist to size positions, using a risk reward based position sizing method means that a trader will take larger positions when the trading opportunity seems more likely to be profitable. As long as the risk taken on each still falls with acceptable risk taking parameters, then this can be a successful enhancement to a trading plan.
Perhaps the easiest way to size positions based on the risk reward ratio would be to first compute the ratio, and then take positions only if it is better than say 1:2, for example. Then, a trader could take a position in direct proportion to how profitable the trade might be.
For example, a trader observing a 1:2 risk reward ratio for a potential trade could take a two lot position. Similarly, they might take a three lot position if the ratio was 1:3, or a four lot position for a ratio of 1:4, and so on.

The Risk-Reward Ratio for Your Overall Forex Trading Business

In order to gain a suitable assessment of the business risks that you may face when trading forex, you can perform a more advanced form of risk/reward analysis.
The steps to go through when performing such an analysis might go as follows:

Step #1 - Research Possible Risks -

You will first need to do enough research into your new forex trading business so that you can effectively foresee any potential risks that may arise.

Step #2 - Estimate Potential Losses and Rewards

Now reasonably determine the potential financial loss that you might incur as a result of the risks you foresee as possible coming to pass. Also compute the potential financial rewards that you hope to earn from forex trading.

Step #3 - Probability-Weight Potential Losses and Rewards

An optional step would be to weight each risk and reward by your best estimate of the probability of it actually occurring in your particular situation to get a set of probably-weighted potential losses. You can then sum these weighted losses up to get a total loss number and can do the same with the weighted rewards.

Step #4 - Compare Risks to Rewards

Now look at the sum of the weighted or un-weighted potential losses and compare it to the sum of the weighted or un-weighted potential rewards. This will give you a risk/reward ratio that you can use to see if your forex trading business makes sense.
Basically, after performing a probability-weighted risk/reward assessment for your forex trading business, you should see a substantially higher chance of success, preferably by a factor of at least two, than your chances of loss.
If not, then be sure to ask yourself why would you want to enter such a risky business in the first place since your time might be better spent elsewhere.
The probability-weighted risk/reward assessment would also help you to take larger positions when you are more certain about the outcome for a particular trade. In essence, using this technique would allow you to take bigger positions when a trading opportunity presents itself with a high probability of profit and a high potential return.
Alternatively, smaller positions would be taken for lower probability trades with lower returns.

The Importance of Managing Risk

Without a clear concept of risk, a trader can easily take on more risk than they can handle which eventually leads to cleaning the trader out of their money and the trader going back to their day job.
A successful forex trader typically knows not only the risk reward on any given position, but what percentage of the account is at risk on any given trade. An accepted size for an individual position in a forex account puts no more than 2% at risk on any given forex position.
The amount of risk that a trader assumes on any given position can be immediately assessed with the size of the positions in relation to the size of the account.
Building an account gradually and increasing the trading units as the size of the account increases makes the most sense. Nevertheless, many novices begin trading without assessing their risk and without sizing their positions according to sound money management principles.
Remember that trading in the forex market has a very high risk factor, regardless of what you may have heard. Trading in the forex market is a serious business if you value your money, so it makes sense to treat it that way by having a sound trading plan that incorporates good risk management practices.
Further reading:
Read about other methods for position sizing here.
You can read more on risks here.
The relative risk of a forex portfolio.
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

Why Most Forex Traders Fail: Do You Have What It Takes?

Updated: April 25, 2016 at 8:38 AM

Forex trading just like any trading is a lot about psychology. Do you know the most common pitfalls among failing forex traders? Do you have what it takes to become a successful forex trader? This is our most comprehensive article in our trading psychology section where we'll go through both psychological reasons for failing but also some other important reasons. Hope you'll both enjoy and learn from it.

First the psychological reasons

After going to the trouble of developing and implementing a trading plan, why would a forex trader ever begin breaking their own trading rules?
Each individual trader will have a different answer to the above question. In many cases, inexperience is the first culprit. "Rules are meant to be broken" simply does not apply when trading in volatile market environments, as many a forex trader can attest. Unfortunately, many trading novices seem to choose especially volatile times to break their own rules, just when they should not.
A series of other reasons typically arises for more experienced traders, but whatever the cause, losing discipline with one's own rules can often lead to a trading blow-out. This can put the trader firmly out of business regardless of their previous trading success and experience.
One of the pitfalls of not having a trading strategy or ignoring a well-developed one is following your emotions when making trades. Fear, along with greed and hope are the main trading emotions that make the forex market move. Because of the inherent fear of losing money that affects everyone involved in the forex market, fear could be considered the market's number one emotion.

Fear

In general, the emotion of fear arises from a perceived threat and developed as a natural defense mechanism in most animals. The limbic brain, which makes up the most primitive and reptilian part of the brain, controls fear which originally took the form of the "fight or flight" self-preservation response characteristic in all higher animals.
While losing money is the apparent cause for fear, the root cause is a fear of poverty; no one wants to be poor. The fear of poverty is another deep-seated fear that society has programmed into its members and directly affects the trading community.

A Forex Trader's Fear Responses

Several types of fear arise often in the course of trading whether consciously or unconsciously, these emotional responses include:
• The fear of failure
• The fear of missing out on potential profits
• The fear of losing everything or impending doom
The fear-based emotional responses cited above find their expression daily in the markets and often contribute to trading losses unless appropriately managed. Nevertheless, fear can be extremely useful in the event of calling the market wrong, as W.D. Gann, a well known trader from the last century noted "Fear will often save you if you act quickly when you see that you are wrong."
Many professional traders will admit to allowing the gut feeling of fear to give them an indication as to the right time to get out of a trade. This applies to situations where the trader is either taking a profit or cutting losses short. Another Gann quote on fear sums it up nicely: "The fear of the market is the beginning of wisdom."

How Fear Manifests in Forex Trading

Having a great trading system and all of the technical and analytical tools for success in trading will not suffice to be successful; a trader has to have the right mindset. This can only be accomplished by learning to control emotional responses when trading and in all trading situations.
An emotional response which can adversely affect a forex trader involves fear impeding the trader from taking action. This can be especially damaging if the trader has a losing position and finds themselves paralyzed while the market continues moving against them.
This type of response may also impede a trader from taking advantage of a trading opportunity going against their own trading plan and allowing fear to prevail over their own instructions.
Another instance of fear which arises during forex trading tends to happen after the trader has made a losing trade. Because of a lack of confidence caused by the previous losing trade, the forex trader might be too afraid to jump back in regardless of an opportunity to make back the money lost on the losing trade.
Fear will also cause a person to exit a profitable position earlier than would be necessary. This reduces potential gains and makes you unable to absorb inevitable losses longer. It is important to be able to absorb these losses long enough for your gains to outweigh them.
The fear of loss makes up a chief component of the forex market's mass psychology, and it can lead to major market panics as people scramble to get out of positions at almost any price.

Dealing With Fear When Trading Forex

Basically, when dealing with fear, keep in mind that fear relates almost exclusively to future events. This could take the form of prolonging an unacceptable situation or of making a present situation worse.
A good way to deal constructively with fear is using fear to replace hope which can be extremely detrimental to a trader. For example, instead of thinking, "I hope the market will come back," you can replace that thought with the much more helpful, "I'm afraid I'll lose more money." This thought replacement technique also aptly illustrates the dilemma that a forex trader faces when they have made a losing trade.
Basically, if you can be disciplined and able to trade with a sound trading and money management system, fear and other emotions can easily be controlled. As long as you "plan your trade and trade your plan," fear can usually be kept at a minimum in your forex trading.

Greed

Like fear, the emotion of greed is common throughout the forex market, and it basically is the excessive desire for more than you need.
In many cases, greed can manifest in the common trading errors of overtrading and running winning trades into losers.
Greed can also cause a person to stay in a losing position beyond the time when an objective trading strategy would call for an exit. This obviously results in a larger loss which then ultimately exhausts your capital.
Most people do not have any idea of how greedy they really are until after they start trading. Having a clear profit taking component of your trading plan can help overcome this emotional obstacle to success.

Hope

Hope can be one of the most damaging market emotions to a forex trader's success because hope can coddle a forex trader into holding onto a losing position in the hopes that the market will come back.
The market has already proven the trader wrong, but hope makes them stick with the losing trade, often leading to disastrous results for their trading portfolio.
In fact, the hopeful trader would be far more reasonable in fearing losing more money on a losing trade.
Nevertheless, hope can be used constructively by traders when they hope to make more money on a winning trade and therefore let their profits run on.
Letting the emotions of greed, fear and hope dictate your trading activity is one of the major reasons why most forex traders fail.

Excitement

The emotion of excitement can often arise after a trader has made a winning trade or when the market moves sharply when a trader has a position causing a burst of adrenalin.
At this point, the trader needs to remember in the heat of that excited moment, that their success in trading over the long run will be determined by how disciplined they are in following their trading plan.

Elation

Elation will generally arise when the trader has made an impressive unrealized profit on a position. The boost to their confidence may lead them to think they can do no wrong, and that can be when the problems start.
Not only does the elated trader need to take their profits out of the market by liquidating the trade and realizing their profit, but they also need to stick to their trade plan in doing so.
Nevertheless, the elated trader may throw caution to the wind and disregard the profit taking portion of their trading plan. This can even have the unfortunate result of them frittering away the handsome profit they had originally seen on the trade.
Remember, you cannot take unrealized profits to the bank. Realizing profits in a disciplined way is an essential part of trading successfully.

Lack of Discipline

Lack of discipline leads to emotional trading and is another of the major reasons why most forex traders fail. Losing discipline in a trading situation takes place every day in the market, and any of a number of causes and excuses are used by traders to justify their mistakes. Unfortunately, more often than not, a trader that loses discipline will eventually lose money as well. That is, unless they are extremely lucky, of course. Still, the fact remains that they are just not playing the odds when it comes to their forex trading activities.
At a certain point, the trader who has lost all discipline acts in a way remarkably reminiscent of a gambler, since they have virtually stopped being a business person when it comes to their trading.
Such a gambler might get favored with a long string of winners, only to gamble away all of their winnings and more before leaving the table. Of course, they had ample opportunity to walk away with a profit, but they did not have the discipline to do so.
In essence, any forex trader that wants to be in the business over the long term needs to think of their trading activities more as a business, than as a gambling game.
Basically, having and implementing a trading plan makes up the trader's method for minimizing emotional reactions while trading. Having a set of rules which are of a purely technical nature, is the ideal method for approaching forex trading in an objective manner. 
Having a solid trading plan and the discipline to follow it can minimize losers while maximizing winners. Because of the variety of situations which can arise in the course of trading, a trader is well advised to include every possible trading scenario that can occur in their trading plan.
Once you've developed an objective trading strategy or system, you must follow it! In developing your system prior to your first trade, nothing is at risk. For this reason, you should be able to develop a trading strategy that is objective. Once you've started trading, risk and reward become reality and you can get carried away by your emotions. Adhering to your objective strategy through self discipline is the only way to avoid this problem.

Other reasons why forex traders fail

Not entering a stop-loss order

An example of an easily avoided mistake which tends to be made often involves not entering a stop-loss order immediately after entering into a position. Some traders that trade forex without stop-loss orders can see their accounts wiped-out on just one all too common currency spike.
Trading without a reasonable risk assessment and management strategy can spell disaster in the highly leveraged game of the forex market. With leverage ratios of up to 500:1 for some accounts, a large sum of money can evaporate in what seems like an instant. In the U.S. the maximum leverage is 50:1 for majors and 20:1 for minors.
Purposely trading without a stop-loss and prolonging a losing position can arise from the trader's perception that the market will turn around if only they are patient, which may or may not ever happen. Basically, the trader has already psychologically placed themselves at a disadvantage.
An initially small loss can often begin to grow, weighing on the mental state of the trader "riding it out". They are now stressing over the growing amount of the loss as the account is put at risk. The trader eventually chokes on the growing loss and closes out the position near its worst point, only to see the market subsequently recover. They are devastated and so is their trading account.
They then typically sit on the sidelines licking their emotional wounds and watching the market make an equally strong recovery. Unfortunately, this scenario plays itself out far too often among forex traders that do not manage their risk with discipline and according to a strict trading plan.

Lack of Capital

One guaranteed experience in the forex market is loss. If you are trading, you are guaranteed to lose on some of your trades. You need to have the capital to sustain those losses that will, at times, outweigh your gains. This problem becomes even worse when traders make up for their lack of capital by using heavy leverage. Of course, all forex trading relies on leverage, but try to grow your capital so that decreasing leverage is required, or so that you can maintain backup liquidity. Taking too much risk in a single trade often occurs in the increasingly slim hopes of making back the lost funds in a bigger loss, again when the trader cannot control their emotions.

Unrealistic Targets and Goals

Another reason why most forex traders fail is because they have established unrealistic targets and goals. These impractical goals will either cause a person to take more risk than they should on individual trades, or they will encourage more trades than would be necessary within the bounds of a balanced and objective trading strategy.

High-risk Aversion

While taking on too much risk can prove disastrous to the forex trader, a high-risk aversion will limit a persons ability to take the necessary risks to be profitable and successful in the forex market. Forex market trading is not for the faint of heart!

Poor Choice of Broker

If the broker that you chose does not have the skills, knowledge, and tools necessary to properly advise the new forex trader, the possibility of failure increases significantly. Read reviews of the most reputable brokers out there.

Lack of Knowledge

Just as it is with any business, whether you are selling products or services, trading futures, or trading in the forex market, you need to know the business in order to be profitable. Find or buy a forex trading course from a trustworthy source, and work through it completely. This will give you the education you need to properly prepare your own trading strategy, evaluate potential brokers, and help you to avoid the common causes for failure mentioned above. After becoming familiar with the market, push yourself to improve and excel. Ultimately, failure happens because people never spend the time or effort to do well.

The Forex Trader's Solution

While eliminating the emotional element in trading is unlikely, the way emotional and character elements have been minimized by seasoned professionals, is by education, confidence and a trading plan.
Being well educated on the economic forces that cause prices to change and considerable familiarity with the financial product or commodity one is trading, give the trader confidence.
Confidence in trading makes up a large part of a successful trader's attributes. Nevertheless, in order to be completely confident, a profitable trading plan which allows the trader a framework to trade upon is the other part of a successful trader's secrets. Learn to trade forex confidently for success.
The trader needs to strictly adhere to the trading parameters of a concise, complete and well-tested trading plan. Any such plan should contain a risk-management component and be relatively easy to follow and implement in practice.
As an additional measure of insurance, position sizing in decreasing amounts as the portfolio size decreases along with less frequency of trades and a focus on higher probability trades is recommended. Read more on forex position sizing strategies.
This helps add a further cushion to the portfolio in the event your system undergoes a string of losing trades in unfavorable market conditions. While such a strategy for handling a long string of losing trades will hopefully never be used by a trader, having one in the event this dismal scenario occurs is certainly preferable to not having one at all. Read here for information on how to design a forex trading plan and rules.
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.

Trader Personality Types

Updated: April 25, 2016 at 9:17 AM

Dr. Van K. Tharp is a professional psychologist and trader coach who has come up with a very interesting set of trader personality types that novice forex traders can use to help assess their psychological suitability for the forex trading arena.
Each of the fifteen trader types identified by Dr. Tharp conforms to a certain trading psychology profile. The characteristics, strengths and weaknesses of each of these profiles are discussed in greater detail by Dr. Tharp in his writing on the subject, as well as on his website.

The Trader Personality Types

Dr. Tharp's trader personality profiles include the following fifteen general types:

·         The Accurate Trader

·         The Administrative Trader

·         The Artistic Trader

·         The Adventurous Trader

·         The Detailed Trader

·         The Facilitative Trader

·         The Fun Loving Trader

·         The Independent Trader

·         The Innovative trader

·         The Planning Trader

·         The Socially Responsible Trader

·         The Spontaneous Trader

·         The Strategic Trader

·         The Supportive Trader

·         The Values Driven Trader

Dr. Tharp offers a free trader personality test assessment on his website that you can take to find out what type of trader personality group you tend to fall into.

Characteristics of a Successful Trader

Dr. Tharp has identified three primary psychological elements which all of the great traders he observed tend to share. These desirable traits for traders consist of the following characteristics:
1. Being able to grasp the big picture, to connect events and to identify trading opportunities.
2. Being able to use logic and analysis to base trading decisions on.
3. Being orderly, decisive and able to operate sequentially.

Personality Types Best Suited for Trading

Only two trader personality types have all of the desirable characteristics of a successful trader. These are the Strategic Trader and the Planning Trader.
Traders that fall into these personality types have the best probability of success as traders. Not only do they tend to have the greatest financial success when trading, but they also have what it takes to operate profitably under a variety of market trading conditions due to their mental flexibility.

Personality Types That Achieve Success With Some Work

A larger group of ten trader personality types have one or two of the desirable personality characteristics of a successful trader.
These ten moderately successful trader types are: the Detailed Trader, the Facilitative Trader, the Innovative Trader, the Spontaneous Trader, the Independent Trader, the Administrative Trader, the Values Driven Trader, the Socially Responsible Trader, the Accurate Trader and the Adventurous Trader.
These traders would do well to work on developing the trait or traits which they lack out of the three listed above that are shared by successful traders.
With some self observation - and after performing appropriate work on their behavioral responses as traders - they can also usually become successful traders like the Planning and Strategic Traders.

Personality Types That Find Successful Trading Especially Challenging

At the bottom of the trading potential totem pole Dr. Tharp has found three trader personality types that are unsuitable to trading forex for a variety of reasons, but largely because they lack any of the aforementioned characteristics of successful traders. These consist of the Artistic Trader, the Fun Loving Trader and the Supportive Trader.
Individuals that fall into this group are somewhat challenged by trading and will often find trading successfully to be very hard work. These traders may do better as investors by lending their money to others to trade forex for them.
Nevertheless, a possibility of success exists for such challenged traders if they are able to adjust their habits toward those of successful traders. They can attempt to do this based on regular feedback, self observation and adjustment, but they will need to be committed to pursuing their goal of trading successfully with considerable persistence.
Further reading:
Why traders lose discipline?
Trading Forex and the psychology of winning.
Learn to trade forex confidently for success.
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.