I get emailed daily from traders who pour their hearts out to me about their struggles with Forex trading. And they always ask me the same thing. “Teach me how to trade Forex…Teach me where to buy and sell.” And yes, you absolutely need to understand the basics of support and resistance, price action, candlestick formations and understanding trends. And it is vitally important to know how to choose your entry and exit points. But the #1 reason why 90% of all traders fail in Forex is because they do not have a solid equity and risk management plan.
I recently received one of these emails for help from a gentleman with an attached screenshot of his MetaTrader 4 account. He had an account balance of $1,500 and had just bought the EUR/USD. He bought about 12 positions over a 1 hour period and their account was hovering a loss of $450. THAT…is bad equity and risk management.
So let’s talk about what I feel is the most critical step in your Forex trading….Developing an equity and risk management plan.
The first step is to make sure your mindset is right. I often see traders with a $200 account risk 50% or more of their account balance on 1 trade and wonder why keep blowing their Forex accounts. That is gambling. And if you come to the Forex market, where 90% of traders are losing and the other top 10% are taking all of the money from the 90%, you are going to have your butt handed to you.
So the first step is to STOP GAMLBING. To be successful in Forex you need to think like a professional Forex hedge fund manager. You have to think long-term about what returns you would like to see at the end of the year. 5% to 12% a month is very achievable in Forex. But if you expect to take your $500 account and turn it into $20,000 by the end of the year, it is not going to happen.
The second step is for you to understand your risk tolerance. How much could you lose on a trade without it affecting you emotionally? Based on your current strategy can you lose 10 trades in a row and still be in business? I would suggest that you trade no more than 2% of your account balance on any given trade and never risk more than 5% of your account on all of your trades at one time. I personally never risk more than 1%. Because when you risk too much on 1 trade and that trade loses, the emotional response that you have is usually one of revenge and thoughts of “I have to make this back.” And when you have that mindset you are geared to lose. You MUST be able to trade without your emotions taking over. You will lose trades. But it is a part of business and if you have the right risk management protocol in place it will not bother you when you lose a trade.
So let’s get into developing your equity management plan.
Let’s say you decided that if you lose a trade and lost 2% of your total account balance on a trade that you would be very comfortable and non-emotional about the loss. You have already done your top down analysis and you feel you have found a potential trade. Before you enter the trade you need to know where you will place your stops and where you will pull your profits.You already have a picture either on your charts on in your mind exactly how you are going to trade this trade.
The example below shows a screenshot of the AUD/JPY 1 hour chart. We are only using this for the purpose of laying out your stops and profit targets in advance. But you will notice that we had a swing high, a swing low and then price came up to the 61.2% Fibonacci retracement (our entry level) where we are selling this pair. In this trade example you are going to need a 50 pip stop. And let’s say you have a $5,000 trading account. You first need to determine your maximum risk. 2% of $5,000 is $100. Now you have to divide that $100 between those 50 pips. And the number is 2 which means you are willing to risk $2 per pip for 50 pips. If you take this trade and you get stopped out, you are only out $100 which is 2% of your account balance. Are you with me?
So looking at the example above it also looks like the profit target, which is where we want to close our profit is also 50 pips. which means if price move in your favor that you will make $100 or 2% return on your account. Do you understand how to calculate this?
Now, the question is “Josh, would you take this trade?” And my answer? No. Why? Because the Risk/Reward ratio is too low. In this example I am risking 2% to make 2%. This is s 1:1 Risk/Reward ratio. Now, if you are scalping the market 1:1 is about all you are going to get. But other than that, I never like to take a trade unless the Risk/Reward is at least 1:2. Which means, using this example, that if I am risking 50 pips and 2% that I need to feel that the trade will give me 100 pips and 4%. If you trade this way you can actually lose 50% of your trades and still be profitable.
So tighten up your equity and risk management protocol, commit in advance that your maximum risk exposure per trade and the minimum acceptable Risk/Reward and you have the beginnings of your very own equity and risk management plan. In the near future I will put together more info on this. In the mean time watch the videos below on equity and risk management…Happy Trading.