11 Rules of Effective Capital Management On Forex
There is no successful Forex player that has achieved a good and stable result without an efficient money management system. Wise and weighted up capital management allows for playing on the high-risk market thanks to marginal trading. In this article we are going to have a look a the main rules and principles of money management on Forex.
Rule № 1
The size of the margin must not exceed 10-15% of the deposit.
This rule helps calculate the margin for the orders to open. The remaining sum is necessary for normal work of the trader and for avoiding force majeure on the market: Forex may behave unexpectedly.
As for the suggested margin, its maximum size is not always the same. For example, Murphy suggested that it should not exceed 50%; however, other sources advise to stick to the margin amounting to 5 to 30% of the deposit. Anyway, the approach should go in line with the initial size of the deposit, as long as the smaller it is, the harder it is to go along the conservative way.
Rule № 2
The investment into one instrument or a group of assets with high correlation coefficient must not exceed 15% of the deposit.
This helps diversify risks and avoid strong dependence on the result of the trade.
On Forex there are groups of instruments as yen pairs, groups of allied currencies like EUR/USD и GBP/USD, AUD/USD и NZD/USD, metals like XAU and XAG and so on. Currency pairs of one group normally move in the same direction, slightly lagging behind one another. Thus, large investments into one instrument or the assets of one group go against the rules of risk control. The principles of efficient funds use are also to be kept in mind. Money should be allocated in such a way that a trade resulting in a large loss does not rid the trader of the whole deposit.
Rule № 3
Each instrument must imply a risk no bigger than 5% of the deposit.
This rule seems rather arguable, and its feasibility to a big part depends on the size of the trading capital. The risk of the trade may vary from several tenths of a percent to 10-20%. It does not relate to traders who do not regulate risks at all, the only limit being the size of their deposit.
If we turn to classics, Elder suggested 1.2-2.0% risk for one trade, Murphy – 5.0%.
Rule № 4
Define the level of diversification of instruments.
Regardless of diversification being one of the most efficient ways of protecting money, one should not overuse it. There should be a certain balance between concentration and diversification of assets. Excess diversity of the instruments used in trading makes the trader lose their concentration which may lead to untimely reaction to the market movements and a decrease of productivity.
Allocation of assets to 5-6 different instruments of various groups is considered most efficient. The bigger the coefficient of inverse correlation is, the higher is the diversification level.
Rule № 5
Put Stop Loss orders.
The main purpose of Stop Loss order is to limit the trader’s losses. Some put them every time opening a trade, others do so only for the time of their absence from their workplace. However, it is always worth remembering that Forex is an unpredictable market, and the movements of currency pairs can be sharp and quick. As a consequence, traders may suffer excessive losses, because they may not react in time, even sitting in front of the computer screen.
The size of a Stop Loss depends on two factors: the size of the loss that the trader is ready to suffer and the situation on the market.
Let me give you an example. The trader’s deposit is 1,000 USD. The risk of a trade is 5%. The volume of the trade is 0.02 lot. In such circumstances they can afford a loss of 50 USD, and in case the price is 0.1 USD per 0.01 lot for a pair, as, say, with GBPUSD, the Stop Loss should be no farther than 250 points from the entrance to the position.
However, a trader should take into account not only the values, depending on the affordable risk, but also the market situation. It is the price chart that determines the points for Stop Loss placement. And if the chart tells us to place the SL 300 points away from the entrance while we have only 250 points available, the order itself requires revision, so that the risk level was in compliance with our rules of money management.
A trader is interested in placing a Stop Loss as close to the current price as possible to minimize the losses; however, most often it leads to a result far from the desired. The trader gets a lot of small losses that can accumulate in a substantial sum. At the same time, too remote stops can lead to large losses at one blow, that will eliminate all previous profit. That is why one should always follow the market movements, placing Stop Losses.
Rule № 6
Calculate the profit/risk ratio.
Before opening a trade, one should decide, how much profit they are planning to make (where to place a Take Profit) and what loss they can afford (where to place a Stop Loss).
Playing on Forex, a trader always risks losing their assets, and there may be much more losing than profitable trades. What is more, the former may go one after another, 3, 5 or 10 in a row. Of course, preliminary testing of the trading system on long timeframes helps get prepared to such scenarios. However, the final result will largely depend on the quantitative prevalence of the profit over the losses. In order to create such prevalence from the start, one should enter the market only when the expected profit surpluses possible losses 3 times at least. Saying other words, the profit to loss ratio should be as 3:1 or more. In this case one profitable trade can cover up three losing ones, and the trader will be able to remedy the situation, avoiding a drawdown too deep. The trader’s business is maximizing the number of profitable trades and minimizing the number of losing ones.
Rule № 7
Work with several orders.
If a trader is willing to open several positions, it is advisable to combine long-term and mid-term orders.
Orders of the first category are opened in the direction of the main trend, aiming at long-term presence on the market. In such cases long stops are the best as they allow for staying on the market during pullbacks and price consolidation. These positions are aimed at receiving large profit. Short-term orders, in their turn, require shorter stops and profit-taking levels. Trading in such cases is aimed at getting small profit in each position and may take place either along the trend or along correcting pullbacks.
Rule № 8
Aggressive and conservative trading.
Conservative trading helps a trader yield stabler results in the long run, but has low efficiency in short-term trades.
The desire to get as much profit as possible in a short timeframe, lying at the basis of aggressive trading, is feasible only when the price is moving the expected way. In the times of trend reversals, when players switch to trading in the opposite direction, the losses suffered by aggressive traders may have disastrous consequences.
Rule № 9
Compliance with the rule of opening positions.
Entering the market, there are certain rules to follow:
- A trade is open only when the main signal combines with at least one minor signal;
- Before opening a positions, the parameters of an order are to be firmly set: price of opening, position volume, Stop Loss and Take Profit (i.e. risk limits and the profit to risk ratio), as well as the expected time of presence on the market;
- When opening an order against the trend, one should select trading signals more carefully and limit the length of the trade, not counting on large-scale movements;
- During the flat period it is better to limit oneself by the width of the area and hold the positions for a short time.
Rule № 10
Compliance with the principles of following up open orders and partial closing before reaching the goals.
When your orders are on the market, try to comply with the following rules:
- If the price has not reached the chosen goal, and the market situation has changed, the technical analysis speaking against the initial forecast, close the position without doubt;
- Close the positions partially, if you receive a loss bigger than you have expected, or the price has reached the goal. Do not hold the positions for too long hoping for bigger profit – most often it turns out a reduction of profit or even a loss;
- Do not do anything in the following cases:
- If you suffer a loss (regardless of whether it is big or not, planned or not), wait a little, do not open new trades, hoping to get back what yo have lost immediately. Keep calm and let the market form a strong signal for entrance;
- If the price sticks to the same level for a long time after opening an order – have your patience, your order may not yield positive results right away upon opening;
- If the price has not reached the goal, but the market situation is in accordance with your forecasts.
Rule № 11
Compliance with the rules of closing orders.
Close your positions in the following circumstances:
- The planned time of the order’s presence on the market is up;
- The price has reached the estimated goal. Do not hope for more – moving the Take Profit away, you are breaking the calculated and set rules of trading;
- The price has reached the Stop Loss. The hope for an upcoming reversal does not just go against the rules of money management, but also leads to increased losses. If you trade aggressively and in large volumes, using averaging (topping up losing orders), you may lose your deposit even quicker. There is an unspoken rule on the market: the price will inevitably make a turn – right after your deposit has been drained. You may not take my word but you better not make sure yourself.
As soon as you start working out your own rules of money management, take the following into consideration:
- Placement of a Stop Loss and Take Profit is compulsory. Some traders use locking instead of Stop Loss, which means the loss is not locked in but covered up by a contrary order of the same or bigger volume. This tactics is available at a widespread trading platform MetaTrader 4; most other platforms do not provide this service. If you are a beginner on Forex, this option will only lead you to quicker losses. Do not try it before you gain experience as locks are to be open the right way.
- Keep a balance of profit and risk. Remember that making it lower you reduce the number of attempts to enter the market, as well as the reserve for future mistakes. Even experienced traders have lots of wrong attempts to enter the market, sometimes much more than the right ones, that is why you should raise your chances for winning from the market.
- Placing a Stop Loss, keep in mind that it should be at least 40-50 points away from the entrance. The possibility that you will “catch” a peak or the very bottom is quite small, while a Stop Loss placed too near has virtually 100% chance of triggering. An error at the entrance is usually 10 to 15 points, add some 4-5 points of spread and take into account the “noise” volatility of instruments (some 15-20 points). As you may see, a “gap” for free price dynamics should not be less than 40-50 points.
- Take into consideration the previous calculations, set up an optimal level of Take Profit in relation with the profit/loss ratio – it should be no less than 120-150 points away from the entrance price.
- Such a Take Profit can be reached in 2-3 days. If during this time the price did not go in the right direction, it is most likely to move in the opposite direction soon. That is why there is no need to hold the position and get a Stop Loss; you should better close the trade without doubt.
- Opening a position, make your margin no more than 10-15% of the deposit, while the risk should be around 5%.
- Use a Stop Loss to minimize your losses or protect some profit already yielded by the trade. Do not forget that the closer it is to the current price, the higher the possibility that it will trigger. The price can launch your Stop Loss by an unexpected move and rush at the goal, leaving you behind, when it is too late to enter the market.
- Never top up a losing trade.
We have discussed a number of recommendations that will be especially useful for those traders that have just started playing on Forex. As you become more experienced, you may work out your own rules and principles of capital management, but let the above said be the bones that you will envelop in the muscles of your experience.
I suggest that we should continue discussing the rules of money management in this topic: in the commentaries tell us about your trading principles, share your experience as it may be useful for somebody.