One of the most important skills when investing in forex is good money management. This is essential to protect your assets and maximize your return. In this series of three articles we explain what money management is, why it is important and which money management strategies are suitable for starting forex investors.
Money management is also known by other names: bankroll management, risk management or asset management. It all comes down to the same thing: making the best use of your investment capital to earn the most with forex in the long term. In short, this means that you take your currency positions in such a way that you make maximum use of the lucrative opportunities that the forex market offers, but at the same time protect yourself against disastrous losses if things go wrong. The first half of this principle is not a problem for most investors; extensive attention is also paid to this in the strategy section of our website. It is the second half where the shoe pinches.
The importance of money management
As a forex investor you must realize that the element of uncertainty is inherent in investing and unavoidable. You can be such a good investor and find the most fantastic set-ups; you can never conclude them all winning.
Take the following set-up, for example. Suppose the EUR / USD has been moving between the 1.4200 and 1.4550 ranges for a while and is now at 1.4210. You estimate a 75% chance that the pair will continue to move within the range and that they will certainly go up 50 pips in the range today. However, you can also be wrong; if the pair goes down 20 pips, take that as proof that you were wrong and close the position with a 20 pips loss; you estimate the chance of this happening at 25%.
This is an extremely profitable set-up. If you win 50 pips in 75% of the cases and lose 20 pips in 25% of the cases, you earn an average of 32.5 pips in the long term. Yet it would be crazy to invest your entire capital in this position. After all, you lose one in four times and you would have lost everything.
For a professional forex investor, losing his entire capital is the worst that can happen. His capital is in fact his tool with which he can earn money and an investor without assets is like a carpenter without a hammer. Losing a smaller but substantial part of its capital can also have far-reaching consequences. The following table and graph illustrate this nicely.
For example, if you lose 20% of your capital, you have 80% left. The lost 20% is one fourth of the remaining 80%. It is therefore necessary to make 25% profit on the remaining capital in order to reach zero again. That is a good return, but not feasible. As a loss becomes larger, the return required to make up for it increases hyperbolically. Those who have lost 90% of their capital must achieve a whopping 900% return on their remaining capital to get back to it: an almost impossible task that can take a very long time.
For the recreational investor who trades relatively small amounts, losing (part of) his capital may not be catastrophic. He can always put some extra money aside from his normal income to rebuild his forex capital. But of course it is not fun. Of course you prefer to see your starting capital only grow and you never have to look back after the start. That is why it is also advisable for recreational traders to pay close attention to money management.
Money management strategies for starting investors
In later articles from this series we will elaborate on different money management strategies. In this article we start with two simple strategies that are easy to apply for starting forex investors.
Risking a fixed percentage
The first strategy is to never risk more than 2.5% of your total capital in one forex position. That way you would have to close 40 consecutive positions losing (without changing the risk amount) in order to lose your entire capital. The chance that that will happen is very small.
Suppose you set up every trade in such a way that the chance that you win is as great as the chance that you lose and that you win as much when you are right as you lose when you are wrong. (This is a cautious assumption, because in the long run this will not produce a return at all. If you have thought carefully about your strategy, you will either have a greater chance of winning per position, or greater earnings from a profit.) profitably, you then have 102.5% of your original capital and you invest a maximum of 2.56% of that original capital (= 2.5% of your new capital) in your next position. If, on the other hand, you lose, you risk a maximum of 2.44% of your original capital in your next position.
In this scenario you have to close four consecutive positions with a loss to lose around 10% of your capital. The probability of this happening is 6.25% (after all, we had assumed that the probability of losing one position was 50%). With these assumptions, the chance that you will lose 25% of your capital in a bad series of open positions is around 0.05%. And the chance that you suddenly lose half of your capital in this way is slightly less than one millionth of a percent. That is less than the chance that you will win the lottery! It is of course always possible that with a long series of alternately losing and winning positions you lose half of your capital, but that strategy also considerably limits that chance. So a good reason to stick to the two-and-a-half percent rule.
How does this work in practice? Suppose you start with a starting capital of $ 2,000. At each position you open, you may risk a maximum of 2.5% x $ 2,000 = $ 50. For example, if you now want to open a position on the EUR / USD the size of one mini-lot (10,000 units), you place your stop loss at a maximum of 50 pips. Of course you can also choose a tighter stop loss if the set-up gives reason for it. With a stop loss of 25 pips you could even open two mini-lots. As long as you can’t lose more than $ 50 per opened position.
Portioning of your investment capital
The second strategy for the starting forex investor is to divide his actual starting capital into three portions: one of 20%, one of 30% and one of 50%. You deposit the first 20% portion into your forex investment account with your broker (later more about choosing a forex broker), leave the other two portions in a bank account (but in such a way that you do not arrive there). You start investing as if the paid-in portion of 20% was your entire capital. Because the portioning into portions is probably only a small amount, you will certainly be able to do something less strictly with money management than normal, especially with the first portion. Only if you have lost the entire amount (20%) that you have deposited into your investment account, do you deposit the second portion (30%). With a bit of luck you can work it up without ever having to look back, but if it happens that you also lose the second portion, then you will deposit the last and largest portion of your original capital into your forex account.
The reasoning behind this strategy is fairly simple. If you start investing in forex, you still have a lot to learn and the chances of making mistakes are high. You can make those mistakes best if you only have a small portion of your actual investment assets at stake. The chance that you lose the first portion of 20% is perhaps 75%, but you should have learned a lot during that time. After all, you become a better investor by practicing a lot (and by reading the strategy articles here on digitalstico.com). By the time you deposit the second portion of your capital, the chance that you lose it may still be 30 or 40%. If that happens, then you have probably developed into an investor and the chance that you will also lose the last and largest portion of your capital is very small. Compare that with the situation in which you deposit your entire starting capital in one go and lose it (inter alia by lapping the money management rules to your boot) in one go; then you would have lost everything, while you have only learned a little.
Whatever strategy you choose, ensure that you cover yourself against excessive losses. And try to learn from your mistakes, certainly in the beginning. This is how you best develop into a successful forex investor and the foreign exchange market has a lot to offer you. In the following parts of this series of articles we will discuss the theoretical background of money management and give you a number of advanced money management techniques.
By S.van der Tap Pd.Internet Marketer Founder Of digitalstico.com
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