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Lesson 3: Money Management in Forex Trading: The Basics
Risk Management in Forex Trading: The Basics
Reading Time: 4 Minutes
Risk management in any financial market is imperative to attaining any form of consistency.
Applying rules designed to govern risk helps traders and investors mitigate the impact of adverse market moves.
Knowledge of the markets you trade is crucial, and a first step to managing risk effectively.
Misinterpretation of things such as the differences between a base and quote currency, as well as the time of day and its effect on the currency market, can all be costly mistakes.
The trader or investor MUST be fully aware of the markets traded and their method of execution. For example, are you trading CFDs? Are you trading in the Futures market or the Options market?
CFDs, for those unaware, represent a contract between buyers and sellers to exchange the difference between the opening and closing price of a trade. CFD traders are free to speculate on the future direction of a market’s price movements, without taking ownership of the underlying asset.
Ultimately, there’s no excuse for losing money through lack of knowledge.
When trading, you should also never violate the one golden rule which is to only invest funds you can afford to lose.
While you don’t want to be undercapitalised, you also don’t want to be capitalised with funds you can’t afford to lose.
This is common sense.
It’s not wise to invest money that you might need for housing, food, and bills. The essential needs of living should be taken care of first before funds are used for speculation.
Trading with money that is needed for essentials can also have a detrimental effect on one’s ability to objectively trade the markets.
By only investing what I like to call ‘cold money’, you remove SOME of the psychological connection to the money traded.
Operating with a well-defined trading plan is another important theme in risk control.
Think of a trading plan as a road map, designed to guide you as safely as possible from point A to B.
Having clear rules of engagement help maintain trading discipline, avoiding what’s known as psychological risks. As many market participants will acknowledge, the emotional connection trading can awaken is powerful.
It’s all too easy to be swept up in the emotion of the crowd.
Essentially, a trading plan includes everything required to function as objectively as possible, including risk and money-management strategies, trade setup details like entry, exit and take-profit rules for each method employed, and trading goals.
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