In this lesson we will examine the subject of forex money management and how to manage our trades and profits as a forex trade proceeds into positive pips.
Is Forex Money Management Necessary?
Most forex traders think money management is of utmost importance, this is because in many cases the trading system they are using is ineffective. There are three possible scenarios.
Scenario 1 – If the forex trading system you are using is ineffective and does not consistently give you positive pips with demo trades, then you do not need money management because you will never see any positive pips on your demo or real trades anyway, it is pointless to apply forex money management to an ineffective trading system.
Scenario 2 – If the forex trading system you are using is effective at making pips but you are not implementing the system the way it was designed to be used, once again your demo trades will be losers. Once again it is pointless to apply money management until you learn to apply the system correctly.
Scenario 3 – If the forex system you are using if effective at making pips and you are implementing the system correctly, your demo trades will have overall positive pips. In this case forex money management becomes important, and more importantly, profit management. You now have to learn to manage the profits and the occasional small losses or break even stop outs that will sometimes come with any good and profitable forex trading system.
I have heard a lot of forex traders say how important forex money management is, but this is relative. The moral of this story is quite simple, find a forex trading system that works before you even think about money management. Forexearlywarning has a complete trading system that produces pips when properly implemented, so money management and profit management is important to us. Having an effective trading system that produces pips is, in itself, effective forex money management.
Money Management Versus Profit Management
As we have now pointed out, money management is of relative importance. If the forex trading system you are using is ineffective you will lose on all of your demo trades even if you use good forex money management. If you have an effective forex trading system and you study the system and use it correctly then profit management becomes vital so that you are now able to capture those profits.
How do you determine if a forex trading system is effective and is profitable? By demo trading, there is no other way. Demo trading is boring, losing all of your money will be very exciting. Demo trading is good money management. Not doing any demo trading will prove that quickly.
If you come across a forex trading system and you do not demo trade the system to prove that the system works, greed and ego on the part of a forex trader are now in control. Let’s be sensible and commit to demo trading as part of an overall money management mindset. After you have a good level of success paper trading, with a forex trading system that works, then the next step is to start trading with small amounts of real money using micro lots. This way a trader can get a feel for the forex market with a small amount of money at risk and emotions will stay out of the decisions. When a trader does this they can practice scaling out lots while trading micro lots into profitable movements to practice capturing profits, building good profit management habits. This will better prepare any trader for higher quantities of lots and full scale lots trading.
Forex Money Management Basics
The basic concept of forex money management is that for each pip you risk you want to make X number of pips. This is called your money management ratio. If you trade with the right money management ratio and have only 50% trading accuracy you still make a lot of pips, and possibly a lot of money. If you know your money management ratio for a particular trade as well as the pip potential you can decide whether or not to take a trade well in advance and possibly not take the trade at all.
Always know your forex money management ratio. If a trade has 100 pips of potential and you enter the trade with a 30 pip stop at the outset, then the money management ratio is 100/30 or +3.3 to 1 (positive). The higher the money management ratio is, the better.
Some forex trades outlined by the Forexearlywarning trading plans have money management ratios of up to +15-20 to 1, or higher, which is excellent. We teach trading the swing to position style and only take shorter term trades when the market conditions dictate this or if this is the only type of trade available.
Even if your money management ratio is +2.0 to 1 positive and if this ratio repeats itself your account will grow, even at 50% trading accuracy, because you make 200 pips for every 100 pips you lose. Using the entry trade entry verification system we present in this article, which is called The Forex Heatmap®, along with the trading in the direction of the trends of the market, we feel as if your money management ratio will be much higher than +2.0 to 1.
On the other hand, the money management ratio for scalping the forex when trading is negative. It is mathematically impossible to make money scalping and you will wind up losing your mind and your money doing it. It will wear you down mentally. Here is an example of how scalping for 10 pips is negative money management. Your goal is to make 10 pips and your stop order is set at -30 pips, this is a negative forex money management ratio of -3 to 1. Very bad.
In this example the typical forex scalper has a -3 to 1 money management ratio, remember that is a negative money management ratio. Some scalpers trade without a stop and over leverage risking their entire account. This is high risk gambling and your account and financial future is at risk. If you trade 1 regular lot, the risk amount is always the same only the variable is the potential reward amount, this is why scalping can never work with negative money management.
By contrast, if your forex trading style is swing to position trading, where your goal is to stay in the trade for several days at a minimum, then your money management ratio is positive and ranges from about +2.5 to 1 and up to as high as +20 to 1 which is outstanding. Money management ratios of about +5 to 1 or larger regularly occur on the larger time frames and trends. Fresh moving average crossovers on the H4 time frame and larger have very good money management ratios. Combine strong money management ratio with the major time frames and trends of the forex market for best results. Also, if you use The Forex Heatmap® to guide your entries, your accuracy also improves to around 90% positive. This is the correct way to trade the forex and your risk of loss is negligible. This is very good forex money management.
Everyone has losses and some break even stops. It’s going to happen. Just keep them small and manageable and with the proper ratio of wins and losses and the proper money management ratio and you will be fine. You will get stopped out at some point, it is a fact of life and part of trading. But even with a 50% success rate and the proper forex money management ratio your account will grow.
Swing to position trading on the H4 time frame and larger is good money management, scalping is poor money management due to the differences in the potential pip reward versus risk. If you trade 1 regular lot on all of your trades the dollars that you risk is always the same only the variable is the potential reward amount changes, this is why scalping can never work with negative a money management ratio. Go for larger trends and time frames and use a quality trade entry management system to avoid this. Avoid scalping the forex with indicators, it is the road to disaster.
If a currency pair is consolidating or resting (moving sideways) for a good period of time, then movement starts, it tends to keep moving. Currency pairs that have been moving hundreds of pips for days and days need to consolidate and rest, just like a runner needs to rest after a long run before he or she can begin running again. It is very natural for a currency pair to consolidate. If a currency pair is coming out of a good consolidation cycle and it is in a strong trend, or a new trend is starting, it is much easier for the pair to commence another trend cycle or continue in the direction of the trend and provide a new entry point. Consolidations cycles can be stable or choppy and this may affect your initial stop order price.
If you know the direction of the primary trend of a currency pair using the larger time frames then you can check the smaller time frames (M5 and M15) to look to see how each currency pair of interest is consolidating on an intra-day basis. Some pairs consolidate in a very stable fashion, some pairs bounce up and down when they are consolidating.
In order to illustrate the various types of consolidation cycles we have a discussion of common forex chart patternsto review further. Learn to recognize the most common types of consolidation and retracement cycles that occur. Examples of how to handle trade entries from several of these situations is covered in the paragraphs below. Understanding the characteristics of the pair you want to trade, the direction of the primary trend and how the current consolidation cycle looks is good forex money management and you will be better prepared for the next entry and movement cycle.
Now that you have entered the trade and bought the pair of interest you need to “manage” the entry. This would include: 1. Placement of your initial stop order, 2. Moving your stop order up to break even, and, 3. Closing out or scaling out profitable lots as the trade proceeds into profitability.
Initial Stop Placement
After you enter a spot forex trade you can use these approximate guidelines for initial stop order placement. Initial stops for slower moving pairs should be in the range of 20-25 pips. Just verify where the pair was trading as it was consolidating in the last few hours before the current movement started, or below some of the recent retracement points using a conventional bar chart. For more volatile currency pairs you can add 5-15 pips to your initial stop.
You can also look at the “lows” and “highs” on the smaller time frames and check these prices with a conventional bar chart over the last few hours prior to the start of the movement. Initial stops for buys should be placed immediately below the recent lows as the pair was consolidating for the last few hours of trading prior to the movement starting to the upside. Initial stops for sells should be placed immediately above the recent highs as the pair was consolidating for the last few hours of trading prior to the beginning of the movement to the downside.
In the above example you enter a buy at point 2, and set your initial stop at point 1. At point 3 you scale out lots and move your stop to break even, point 2. At point 4 you scale out more lots. Then move your stop up at your option or leave at break even, excellent forex money management execution.
These are excellent guidelines for new traders but more experienced traders will modify these initial stop guidelines as they develop some experience. These are only guidelines but they are a pretty solid starter kit. The only way to succeed with these guidelines is by doing some level of demo trading or trading with micro lots but this is up to each individual trader to do. There is no substitute for experience with forex money management.
Moving Your Stop To Breakeven
The next step in trade management process is moving your stop to break even. There are four ways to do this.
Time Method – After you enter a trade you can give the trade 30 minutes to one hour to continue in the direction of the trend. After 30 minutes to 1 hour if the trade has moved +40-50 pips or more past the entry price just move your stop to break even. If for some reason the trade stalls at plus or minus 10 pips during this time period you should exit and keep your money to trade another day, but afterwards try to assess why the trade stalled.
Use price alarms – After you enter a trade you can place a price the alarm on the pair at +40-50 pips into profit and when alarm goes off you can move your stop to break even.
Partial Limit Orders and Alarms – After you enter a trade another trade management method would involve the use of price alarms combined with partial exits or partial limit orders. For example if you enter a trade with 6 mini lots you can set a partial limit order to close out 3 mini lots at +40-50 pips and set a price alarm on top of the limit price. The price alarm will serve as an execution notification. When the alarm hits you can move your stop to break even on the remaining 3 mini lots and let those lots ride with the trend. This is referred to as scaling out lots and more options for scaling out lots will be outlined below. Some forex trading platforms also have built in execution alerts.
Slightly deeper stops with no risk – If the pair you buy moves up to +40 pips and you scale out half of your profitable lots you can actually set your stop at -40 pips on the remaining lots, which allows you to maintain a deeper stop at 80 pips from the market with zero risk. You risk your profit but there would be zero risk of loss.
The general philosophy here is to get your stops to break even then let the trend do the work. When learning this process you will get stopped out a few times and the trade will proceed strongly positive anyway, this happens to all traders and is part of the learning process. Getting your stop to break even on every trade is your main job with forex money management job.
Exits and Profit Taking
Now that you are in a trade and profitable we need to further discuss back end money management or profit management techniques. Profit that is unrealized can still be lost and one important component of money management is exiting with your profits. At this point in the process you have already entered the trade and it proceeds in your favor, so you need to take or capture profits. There is a big difference between money management and profit management. If you have a forex trading system that works, then the profit management side of the trades will help you to get to your financial goals.
The assumption here is that you have conducted a reasonable amount of paper trading and micro lot trading that as you move into real money trading you are profitable. We have to make this assumption because if your system does not work all of your paper trades are losers we have to presume that real money trading never commenced and that you were responsible enough and vigilant at protecting your money this way.
Basic Profit Management Rules
There is a basic “rule of thumb” you can use to scale out profitable lots in to strong movements, the basic rule here is to close out half of your profitable lots and letting the rest of your lots ride to see that the trend takes the pair. This general rule can be used on any profitable trade.
Scaling out lots in thirds, fourths or fifths for longer term position trades into strong movements and trends on the larger time frames also works. On successful entries into longer term trends or longer term trades scaling out lots into positive momentum while maintaining a slightly deeper stop works extremely well.
This is somewhat of an unusual method that was shown to me by another trader. Instead of buying or selling 2 regular lots he would buy or sell 200 micro lots. He would scale out profitable positions at each small profit level using partial limit orders that were preset on his trading platform. In other words he would scale out portions of the profitable micro lots as the trade moved forward into various levels of profitability. +20 pips, +40 pips, +60 pips, etc. This seems more complicated but still sensible.
If you are good with multiple time frame analysis, you should have the ability to recognize choppy markets. In a choppy market if a trader chooses not to trade, or enters much smaller positions sizes and takes shorter profit targets, combined with the proper use of our Now Forex Strategy, it is possible to trade under almost all market conditions and make positive pips. Adjustment of position size based on market conditions will reduce your risk and qualifies as good forex money management. Most or all spot forex traders are mostly playing guessing games guessing when they enter a trade from worthless technical indicators. You are way ahead of all of these traders.
More Profit Management Ideas
Incorporating support and resistance into forex money management – If you buy a currency pair it takes about a minute to figure out where the next major resistance is. Always check the higher time frames (H4 and higher) for the next major resistance or support. If you spot the next major resistance and the pair you bought is approaching this price or stalling near this price it is wise to exit some or all of your lots. A little bit of experience and a price chart sure helps. The free trend indicators will give you all of the information you need to assess the next resistance or support level. One more example is if you sell the GBP on any pair and the GBP is dropping across the board, if you subsequently check all of the GBP pairs and they have no support and strong down trends are in place there is no reason to take profit at all. These pairs will continue downward until they approach or hit the next major support levels.
Incorporating multiple time frame analysis and parallel and inverse analysis into forex money management will improve results ad pip totals. Profit taking guidelines should be based on the condition of the larger time frames on that pair or individual currency group strength or weakness. A decision to hold onto a trade longer term should be based on the condition of the trend and the trends on the parallel and inverse pairs. If you buy the GBP/USD and the GBP pairs are all rising and the EUR/GBP is falling and the D1 time frames are all separated and trending then why would you exit?? It is wise to hold this trade based on what the market logic is telling you. “Stop doing what you want to do and start doing what the forex market is telling you to do”
Other Forex Money Management and Profit Taking Topics
If you have an active trade on any currency pair that has moved strongly in your favor you can close out half of your lots, adjust your stop order on the remaining lots and let the remaining lots ride on the larger trends if the trends are strong. If you choose to close out a portion of your lots after a strong move you can do so at the end of the USD session in a time window of 11:00 am EST plus or minus 30 minutes. This is generally when the pairs end their moves and start to consolidate. The general philosophy is to get your stops to break even then let the trend do the work. On any strong positive trades you can close out half of your lots using the “rule of thumb” and let the rest ride with the trend.
You can also run deeper stops with longer term position trades and use profit taking into profitable movements. One idealized example is as follows, if you sell 6 mini lots of the EUR/USD into a long term downtrend at +100 pips close out two mini lots, at +200 pips close out one more mini lot, at +300 close out one more mini lot, etcetera, etcetera. All of this time you can be running a breakeven stop and not be subject to any volatility stop outs at all. Traders complain about getting stopped out all of the time then the pair continues in the trend, this method will work to avoid this problem. You manage profit with exits into positive momentum.
If you identify a choppy market with your multiple time frame analysis analytical skills you must adjust your money management techniques and take profits on shorter movement cycles. In a tight ranging choppy market you should close out at least half of your lots at +40-50 pips, the exception may be the GBP pairs, but in a trending market you should think about closing out half of your lots around +100 to +125 pips or +150 pips more on the most volatile pairs like the GBP pairs. In a trending market you would let the rest of your lots ride. Your profit taking methods would be different in a choppy market versus a trending market.
Common Sense Forex Money Management Topics
1. Knowledge is good money management, knowing how to thoroughly analyze the forex market with multiple timeframe analysis of trends, knowing how to analyze support and resistance levels and price targets, understanding parallel and inverse analysis, writing and executing trading plans is the type of knowledge you need to succeed trading the forex.
2. Admitting that you do not know how to trade the forex and seeking the correct knowledge is good money management because you will avoid losses.
3. Not entering a potential losing trade with emotion involved is good money management.
4. Understanding your risk to reward ratio on any individual trade is good forex money management, knowing the amount of pips you could potentially make on any entry and the quality of the trend (or lack thereof and possibly a choppy market) is good money management. Does the trade you are about to take have a lot of pip potential?
5. Knowing if the market is trending, oscillating or choppy is good money management, in a choppy market you can choose not to trade and wait for better trends to develop. Learning to analyze the entire market and proving to yourself that the market is choppy gives you a valid reason to wait until tomorrow for a new entry, more good money management.
6. Trading the EUR/USD over and over is not good forex money management, you will force trades into the market when no pips are there, wind up scalping the forex and losing all of your money. Trading the EUR/USD every day can no longer be defended.
7. Using trading methods that work is good money management. Technical indicators, forex robots and scalping does not work and there is zero proof anywhere that any of these things works, but forex traders do them anyway and wind up losing money, almost across the board.
8. Understanding what time of day currency pairs move strongly during the London and US session is good forex money management, you will get the best moves and sustainable entries during these times and can exit when the pairs stall and scale out some profitable lots.
9. Stopping real money trading after realizing your system does not work is good money management, because you realize you should have demo traded in the first place to prove that your system works.
10. Demo trading is good forex money management, ramping up to micro lot trading then mini lots is good money management because you get a feel for the volatility and leverage of the forex market. When trading micro lots you can practice scaling out your lots and profit taking skills.
11. Always trading in the direction of the trend is good money management. Having the trends behind you will always lead you to some level of success, and you will hang onto your trades much longer, especially if larger trends are in place on the larger time frames. Are you early in a trend, halfway through the trend, or late in the trend? Checking the larger time frames will always let you know the answer to this.
12. Moving stops to break even is good forex money management.