Basic Forex Money Management

Recently I've been discussing market orders for placing trades. Earlier today I explained some key equity management tips and how to use stops and limits when placing forex trades (the opposite of basic forex money management is the destructive forex gambling mentality).

Related to these concepts is one important money management concept that I want to share before moving on to more sophisticated trading tips.

How do you decide where to set your stop loss order?

There are several factors to consider:

1. Always set your stop loss order at the last level of support if you are buying and the last level of resistance if you are selling*

* small exception:  because there is a spread between the bid price and the ask price (usually 3-10 pips), you may want to set your stop loss order 3-10 pips higher or lower than the last high or low if the stop loss order is tight (that is, if the stop loss is close to the entry point).  Otherwise, you may be stopped out prematurely.

2. Don't risk more than 2-5% of your margin account on any given trade.  If the number of pips between your entry point and your stop loss price is more than 2-5% of your account (remember that 1 pip is about $10) then you should pass on the trade because the risk is too great.

If you risk more than 5% of your margin account on any given trade, you will be overtrading your account. This basic money mangement rule helps you stay in the forex game long enough to trade another day (so you don't wipe out your account with a few bad trades).

In the blog posts that will follow this, you'll learn about where to set your protective stop loss orders for each specific trade you are making.  Nevertheless, the two rules listed above are applicable across the board no matter what indicators you are using to place your market order.

In addition to a stop loss order, you will need to set a profit limit order.

How do you decide where to set your profit limit order?

Your risk-reward ratio should be 1:1.5 for each trade you make.  That is, for every $1 you risk you should seek $1.50 in reward. This is a good rule of thumb when getting started. As you gain experience, you'll learn how to adjust this risk-reward ratio.

Setting your stop loss defines the risk you will take on that trade.  Setting your profit limit defines your potential reward.

For now, make sure the number of pips between your entry and your profit limit is at least 1.5 times greater than the number of pips between your entry and your stop loss. Apply these basic money management principles to become a forex winner!

In my next post, I'll be talking about understanding forex charts. This is where forex trading starts to get really exciting!!!

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