Risk Management and Trading Psychology
Now that you know the basics of how to trade forex, we can finally get into the subject of how to actually succeed. You might think that success mostly depends on your ability to interpret charts and understand the behavior of price.
But actually, that's the easy part.
The most difficult thing to do in forex trading is to maintain discipline while dealing with emotions. This section of the guide will give you some tips on how to do that.
Time and time again, studies have shown that the majority of trades are closed out at a profit. And yet, the majority of retail traders lose money over the long run. How is this possible?
The answer is that most traders lose more on their losing trades than they win on their winning trades.
There's something about human beings that makes it difficult for us to accept losses or allow ourselves to win.
If a trade goes against us, we have a tendency to let it run and magnify our losses. If a trade goes for us, we have a tendency to exit quickly so as to make sure that we don't lose the small gains we've achieved.
Over the long-run, this causes us to consistently lose more than we win. In this circumstance, even if we win more than half of our trades, we still lose money.
It's just human nature.
Luckily, it can be overcome through risk management. So here's how to do that.
The first thing you need to do to manage risk is to make sure you have enough money in your account to be able to trade with.
Many forex brokers will allow you to start with just $25. This is because they offer leverage, which allows you to trade massive amounts of currency with a tiny amount of capital.
I'll talk more about leverage later. But for now, let's just say that $25 is not enough money to trade forex successfully with.
So what is enough money?
Forex brokers have different rules for what the minimum trade size is.
Some require you to buy at least one standard lot (100,000 units) in each trade. Others allow you to enter a decimal amount for “lot size” down to 1/10 of a lot (0.1 lots).
Still others allow you to enter a decimal amount down to 1/100 of a lot (0.01 lots).
To trade an account that has a minimum lot size of 0.01, you need at least $1,000.
Anything less than this and you will end up with trades that are too big for the amount of capital you have. If your broker has a minimum of 0.1 lots, you will need $10,000 to begin with. And if your broker has a minimum of one lot per trade, you will need $100,000 to be adequately capitalized.
Once you're sure that you've got enough capital in the account, you still need to determine how many lots to buy or sell in a particular trade.
Here's the equation for doing that:
You're not a mathematician? Oh, OK. Just use this position size calculator from Myfxbook then.
In order to use this calculator, you need five pieces of information:
- How much money is in your account (account size).
- What currency your account is denominated in (account currency).
- The percentage risk you're willing to take on a single trade. Between 2-5% is reasonable, depending on your personal preferences. But anything above 5% is probably too much.
- Distance between your stop loss and entry point, measured in increments of 0.0001 units or “pips”. There is an exception for the Yen, which is measured in increments of 0.001 units.
- The currency pair that you are trading.
In the heat of the moment, even using a position size calculator can seem too complicated. So another option is to use a piece of software that will do it all for you.
For example Fotis Trading Academy has a useful risk management tool that allows you to drag a virtual stop-loss onto your chart and into the place where you expect to place your stop. It then calculates the correct position size and gives several options for take-profit points.
Placing your stop-loss in the correct place can be tricky.
Place it too close to your entry point and you will get whipsawed. Place it too far away and you will lose too much on your bad trades.
Here are two ways to get it just right:
- Use areas of support and resistance. Has the currency broken upward out of its previous trading range? Place your stop just below the bottom of that range. Or if it breaks downward, place your stop just above the top of the range.
- Use volatility. Use the Average True Range (ATR) indicator to figure out how volatile the currency has been recently. Place your stop that many pips away from the entry point.
Most forex brokers offer leverage. This means they will allow you to buy a certain amount of currency with only a fraction of the money that is otherwise needed to buy it.
For example, if a broker offers 100:1 leverage on a U.S. dollar denominated account, this means it will allow you to buy up to $100 of currency for every 1$ you have in the account. So if EUR/USD is trading at 1.00, you can buy 0.01 lots for just $10.
This might sound wonderful until you realize that your wins or losses come out of the remaining money in your account.
So let's say that you have $100 in your account and you buy that 0.01 lots. And let's say that EUR/USD falls by 5%. $1000 worth of currency minus 5% is a loss of $50. That's half your account!
And what if you don't have enough money in the account?
Because the broker laid aside that $10, there will always be enough money to cover your losses. If the value of your trade falls low enough that it equals the remaining money in the account, the broker will issue a “margin call”.
This means that the trade will be automatically exited at a loss and your “margin” (the money that was laid aside) will be returned to you.
So...to bring back the EUR/USD example again, if the currency pair was to fall by 9%, you would be margin called and the trade would be exited. As a result, your account would go from $100 to $10. Not much fun.
So is leverage all bad?
When used responsibly, leverage can allow you to multiply the gains of winning trades.
In the previous example, imagine if you had a $1000 account. In this case, a 10% increase in EUR/USD would have resulted in a gain of $100, which is 10% of the account.
But in order to have the chance at such a gain without leverage, you would have to spend your entire account just to get that 0.01 lots.
On the other hand, let's imagine that your broker allowed you to buy 0.0001 lots or just 10 units on a single trade.
Then you could lay aside that 10$ and still make a trade without leverage. But in this case, a 10% increase would give you only $1 profit, which is 0.1% of the account.
Because you have leverage, however, you can lay aside that $10 and have a shot at a 10% gain, with plenty of room to handle the ups and down of the currency in the meantime. This is because your account is big enough to handle those ups and downs.
So leverage is a useful tool for any trader. But make sure you use it and don't let it use you!
The final principle of risk management is to never trade when there is less than a 1:1 risk/reward ratio.
In most cases, it's best to trade only where there is at least a 2:1 risk/reward ratio.
But because some scalpers have strategies that offer very high win percentages, it's sometimes possible to be profitable with less than 2:1.
The bottom line is that you can never know whether a trade will go for you or against you.
All you can do is make trades when the probabilities are in your favor. But no matter what, you are still going to lose some trades.
In fact, most successful forex traders consistently lose about half of their trades.
But because they only make trades where there are 2:1 or better risk/reward ratios, each winning trade nets them at least twice as much profit as they lose from each of their non-winning trades. This leads them to be profitable over the long-run.
So how do you know if a trade has a 2:1 risk/reward ratio?
Just count how many pips (0.0001 units) distance there is from your stop-loss to your entry-point. This is how many pips you're risking.
Then count how many pips there are from your entry-point to your take-profit point. If this second number is at least twice as large as the first one, then you're looking at a good trade.
Of course, this is assuming that your take-profit and stop-loss is reasonable.
So ask yourself, is it really reasonable for me to believe that the price could move this high? And is my stop-loss placed wide enough that it will not be triggered without invalidating my trade idea?
If the answer to these two questions is “yes”, then you're looking at a good trade.
If not, move your take-profit and stop-loss and count it over again. If it's not at least 2:1, leave it alone and wait till something better comes along.
It seems to be just human nature to be unprofitable at forex trading.
But the good news is this nature can be overcome.
Practice these principles of risk-management and you'll be well on your way to being one of the select few that consistently makes money at it.
In addition to risk management, the other key to being successful at forex trading over the long-run is understanding trading psychology.
In the rest of your life, you probably believe that you will be rewarded based on what you do. If you are productive, for example, you expect to make money. And if you are nice to other people, you expect them to be nice to you.
The forex market doesn't care how productive you are.
In fact, it often rewards people who are the least productive...people whose lives are filled with concerns other than forex and who only check their charts once or twice a day.
The forex market often dishes out profits or losses in a way that seems to defy reason.
And the normal human reaction is to think that if you could just use this new indicator or increase your position size or really, really pay attention next time, you'd start making money.
But the more you try to force the market to give you profits, the more you lose.
The solution is to realize that you have no control over the markets.
And success in forex doesn't come from being able to predict where the market is going. No one knows and no one can know.
On the contrary, there's a high degree of randomness to the markets. And success comes from putting yourself in a place where these random events can provide you with riches. But only after they first cause you to lose over and over again.
But at the same time, you do have some control over how much money you make in trading over the long-run.
- You can keep a trading journal and go back to it every week to find ways to execute your trades better in the future.
- You can incorporate new indicators into your trading strategy.
- You can learn more about the economy.
But it's easy to fall into the trap of trying some new trick on your charts, then dismissing it when the next trade goes bad, then trying another trick,...and on and on.
The field of trading psychology attempts to deal with this problem by teaching traders how to focus on the things they can control and not worry about the random events that happen in the market on a day-to-day basis.
Trading psychology can be learned by hiring a psychologist or coach who is specially trained to handle the issues that traders face.
But if you don't have the means or desire to hire a trading psychologist, just remember this:
Now that you know how to be successful at trading, let's discuss how to get set up with a broker.