Money Management in Forex: Complete Guide

This article will teach you how to execute proper money management when trading. If you want to learn various methods to manage your account and find low-risk trades then this is the right article for you.

Let's get started.

Profit vs Loss

When it comes to money management, there is a lot of room for development. Many traders either underestimate its importance or are unsure how to begin.

One of the most common questions our students ask is:

'How can I maximise my profits?'

Higher profits result from having more winning trades than losing ones.

However, is maintaining a good ratio between winning and losing trades sufficient for success in financial markets?

- No, it isn’t!

The ratio of winning/losing trades is an important indicator, but it does not have much weight in the following situation:

For example, suppose 90% of your trades are winners and 10% are losers!

It looks good on the surface, but let's assume that a losing trade is 10 times larger than a winning trade!

In other words, one losing trade wipes out the result of 9 winning trades.

Such a situation is not uncommon, especially among novice traders.

They close their profitable positions too soon and allow losing trades to continue, hoping the market will reverse!

- While the market may eventually turn around, can your account withstand the drawdown in the meantime?

Risk-to-reward ratio

This is the relationship between the potential loss and potential profit of a trade.

To calculate it, you compare the distance from the trade entry point to the Stop Loss with the distance from the trade entry point to the potential Take Profit.

In the image above, you can see the Daily chart on EUR/USD where we’ve given you a short trade as an example. The price is around the levels of 1.2150. If you assume that the price will head south, you will be looking to enter short, right?

You can place your Stop Loss around the level of 1.2250, which means approximately 100 pips of Stop Loss. 

1.2250 - 1.2150 = 100 pips

You can then place your Take Profit at the level of 1.1650, which equals to 500 pips of potential profit.

1.2150 - 1.1650 = 500 pips

Now, this is a 1:5 risk-to-reward ratio. This means we’re risking 1 to gain 5 (or 100 pips to gain 500 pips).

You may be saying: 

- “Why not reduce the Stop Loss to maximise my profit?!”

Well, let’s have a look at the following scenarios.

Take Profit > Stop Loss

If you decide to place a tight Stop Loss and increase the distance to your Take Profit to improve the risk-to-reward ratio, you will have fewer winning trades. 

This is understandable, as the price now needs to move significantly more in your favor while having limited room to move against you.

Even though this will reduce your win rate, it doesn’t mean that the overall result will be negative. In the context of the example above, at a 1:5 risk/reward ratio, it would take only about a 17% win rate for you to be a profitable trader!

Stop Loss > Take Profit

On the other hand, you may decide to use a wider Stop Loss and place your target much closer to your entry. Price will need to move just a little bit to reach your target and at the same time, it will have a lot of space to move against you, and this will automatically increase your win rate. 

However, just like with the example in the previous point, the same applies here. 

More winning trades don’t mean profitable trading overall.

Determining a Stop Loss

In Forex trading, you should always start by determining your Stop Loss size!

Even before entering a trade, you should already know where you will place your Stop Loss and how much you can potentially lose on every trade. After determining at which level your Stop Loss will be, you then have to measure the distance from your entry to your SL. 

Now, see if your potential profit is at least 1:1, meaning that you’re aiming for the same amount of profit as you’re risking. If the potential loss exceeds your potential profit, then it’s best to skip the trade and wait for another opportunity.

Usually, beginner traders leave the Stop Loss as their last point of analysis.

Or even worse, they don’t use a Stop Loss at all!

Make sure to keep in mind the following rules and you will reduce your losses to a minimum:

• Never reduce your SL just so you can buy or sell more Lots;
• Never trade without using a Stop Loss!

Determining the level of risk

How much money are you willing to lose if the market reaches your Stop Loss level?

Usually, the amount that you’re willing to lose should be a certain percentage of your account! You should never open trades with random lot sizes and then adjust your Stop Loss to fit your risk requirements. Also, the risk of a trade should depend on the potential of the setup itself. 

At Trendline, we've created a staking system to assess the risk level to the potential of a trade.

This system categorizes three distinct probability levels based on the market conditions, the setup terms, and the various reasons for its execution.

Level of probability / Stake:

• Small;
• Medium;
• Large.

Positions with a medium stake are more likely to be successful than those with a small stake. Therefore, we can afford to enter these trades with higher volume/position size. Of course, positions with a large stake are most likely to be successful, meaning that we can enter with even more volume.

Pip value and position size

The position size is determined by the Lot size. 

There are three types of Lots;

• Standard Lot;
• Mini Lot;
• Micro Lot.

Somewhere you may come across the term "contract" - it's the same thing.

One standard lot/contract equals 100,000 basis units, but with some brokers, it can be more, for example, 150,000.

In each type, the value of one pip is different:

One standard Lot equals 10 mini Lots, and 1 mini Lot equals 10 micro Lots!

For different currency pairs, the value of one pip may vary. But I'll give you a formula to figure it out.

For currency pairs involving the JPY, the formula is slightly different.

• 1p = 0,0001 * contract size * number of Lots (quote currency)
• 1p (JPY) = 0,01 * contract size * number of Lots (quote currency)

Keep in mind that the result is always in the quote currency (the second currency in the currency pair).

Example:

• EUR/USD 1 pip = 0,0001 * 100 000 * 1 Lot = $10
• USD/JPY 1 pip = 0,01 * 100 000 * 1 Lot = 1 000 ¥

Acceptable risk in money management

The next step is to combine what you’ve learned so far and to calculate the volume for your trade.

Example:

Capital: $5000

Risk: 2%

Stop Loss: 100 pips 

Formula:

Capital * % risk / Stop Loss in pips = pip value

5000 * 0,02 / 100 = $1 / pip

2% of $5000 = $100 which means that the potential loss of this specific trade shouldn’t exceed $100. 

Assuming the Stop Loss is 100 pips away from the entry, this means we are allocating a $100 loss per 100 pips of negative movement. Therefore, for every pip, there is a $1 loss.

If you go back to the top of the article, you will see that if the value of 1 pip is $1, then the volume/Lot should be 1 mini Lot or 0.1 standard Lot.

Most traders have no idea what risk they trade with. They place trades without having a bias, let alone calculated risk. If you want to last longer in the market and make money from Forex, think about money management and how much you can afford to risk! 

Learn more about Forex trading from the Complete Guide for Beginner Traders.

Fixed percentage as a money management method

The most common method for position sizing is the fixed percentage approach. In this method, the trader determines a percentage of the account to risk on each trade, usually ranging from 1% to 5%, depending on the account size.

It is always better to trade with a larger account and lower % risk per trade than a smaller account using high risk!

If you trade with $10,000 and set a risk level of 3%, hitting the Stop Loss will result in a $300 loss from your account. The primary benefit of trading with percentage risk is that you always know the exact amount you stand to lose, unlike trading with a fixed volume.

During a series of losses, your account won't experience a significant decline, making it easier to recover. This approach promotes balanced and calm trading, as you have already calculated the maximum potential loss, allowing you to sleep peacefully.

This is the main approach we recommend and use. It can be advanced through the staking system discussed earlier.

You will learn how to use the staking system in our Money Management course.

The reason many people enter into random or fixed volume trades without considering the risk of each trade is complexity.

For this purpose, you must:

• determine where to place your Stop Loss;
• choose the % risk that you will use;
• properly calculate the lot size.

That’s what many traders find difficult.

This is the reason why we’ve developed an Expert Advisor that can automatically calculate this for you. 

You only have to type in your preferred % risk and the Stop Loss distance in pips, and the EA will immediately tell you what Lot size you should be using.

Adding to a winning position

Adding to a winning position involves increasing the size of an existing trade as it becomes profitable. This approach is particularly effective for trending strategies, as it allows traders to capitalize further by adding more trades as the trend progresses.

A disadvantage of this approach is finding the appropriate level to add to your position. Most often your entry should be at the end of a pullback. 

The most important condition for this type of strategy to work is to determine your initial volume for the first entry and then how much you should risk on your next entries.

In case the market reverses against you, your losing positions can very quickly wipe out the gains from the trades you managed to open earlier. To avoid this, your first entry should be with a higher Lot size than the following ones.

Adding to a Losing Position (Averaging)

Along with the Martingale method, this is the most controversial and debated method in the Forex world! This is more of an advanced money management strategy.

Properly using this method can lead to zero or minimal loss trading. However, incorrect application will almost certainly result in you losing your account.

Adding to a losing position involves opening new trades as the market moves against you. This does not mean randomly placing trades in the hope of a market reversal.

While the market may eventually reverse, the drawdown could be too severe for you to endure.

With this tactic, every next trade is executed with a larger volume than the previous one. The concept is that when the market moves in the desired direction, a small movement will offset potential losses from the unfavorable development of the positions.

For averaging to be successful, you must have a clear plan for the total potential loss from all trades if the price does not move as expected. Continuously adding to a losing trade is not a viable strategy.

Also, you must have a strategy on how and when to add a new position. Most often, using support and resistance levels, Fibonacci levels, and trend lines is the best way to do it.

As soon as you open your first trade, you should already know how many more entries you will make in total, what will be the total % loss of all trades, and where to place your next trades. 

Novice traders often misuse this method when in a losing position, unreasonably hoping for a market reversal. They become emotionally attached to the trade and are reluctant to accept a loss, but inevitably, they end up doing so.

Martingale

This tactic involves doubling the risk percentage of the next trade after a losing position. The goal is for the winning trade to offset all the losses incurred from previous trades.

The pros of Martingale are that all accumulated losses can be recovered with just one winning trade, and even add profit to your account on top of that. 

The drawbacks are that over time, a series of losing trades is likely to occur, and eventually, the account may not have enough funds to sustain further doubling.

If you begin a Martingale strategy with just a 1% risk, by the eighth trade you will likely run out of capital to open the next position. 

As you can see in the table above, you won’t be able to double the risk on trade number eight, as you would be about $500 short of the required capital.