Discipline is a key requirement. Forex traders will utilise leverage if they are trading through a margin broker. Leverage gives the trader the opportunity to abuse their account. This is not forex trading. It is addiction, otherwise known as compulsive gambling. The fact of the matter is, that if you have $2000 in a leveraged account at 100:1, you can trade one standard lot – i.e. use $1000 of your deposit as required margin to your broker, who will let you place a $100,000 trade in the market.

Each incremental PIP increase or decrease in that currency pair, if the base currency is a major traded against the dollar – for example – EUR/USD or GBP/USD, will result in a net profit/loss shown in your live account balance of $10 US.

So let’s say you buy one standard lot of the GBP/USD, that is to say, you buy pounds and sell dollars, at the price quoted to you by your broker of 1.5000. Over the course of, for example, 1 hour, the price reaches 1.5050. You then close the trade, by selling back your pounds and buying US dollars again.

You have made a profit of $500 because each pip was worth $10 and you leveraged your $1,000 of your $2,000 into $100,000 through your broker allowing you to trade with leverage of 100:1.

Herein lies the potential problem with this trade. If the trade goes against you, and you end up closing your trade for a 50 pip loss, then your account has lost $500. That’s 25% of your overall account in a single trade and is disastrous.

Therefore, in managing money in forex, it is neccessary to protect your account balance by using risk management which is appropriate for your account size.

This will entail the use of a protective stop, also known as a stop-loss.

A small calculation will also be required for you to trade effectively.

Two forex risk management rules of thumb are: to never allow yourself to risk more than 2% of your account balance in any given trade and always to use a risk to reward ratio which is better than 1:1.

For example, with out $2000 starting account, leveraged at 100:1.

2% of the account is $40 US.

Therefore, in our first trade, we should not risk more than $40 in the trade. This is the maximum loss we are willing to take if the trade does not work out our way. Learning to lose in this way is actually learning to win.

Setting a risk to reward ratio of 1:1.5 would mean whilst our stop-loss is at $40, our take profit is set at $60. If we find a possibility of a 1:2 risk:reward trade, then our stop-loss is at $40 and our take profit is set at $80 profit.

For those pairs which are $10 per pip on a standard lot (such as GBP/USD or EUR/USD), we can calculate how many lots we need to trade on the 1:1.5 trade risking 2%.

2% of our account balance is $40.

We can therefore trade 0.2 lots or 2 mini-lots ($2 per pip) and set the stop loss 20 pips below our entry (if we are buying the base currency – N.B. the stop is set 20 pips above our entry if we are selling the base currency).

Another possibility is to trade 0.1 lots (1 mini-lot – $1 per pip profit/loss) and set our stop loss 40 pips below our entry.

For the take profit on the first trade (0.2 lots trade with 1:1.5 risk:reward) we set this at 30 pips above the entry if we have bought the base currency, in the determination that the GBP/USD exchange rate will go up. We set it 30 pips below the sell entry if we sold GBP against USD, for example, as we are trading on the basis that we think the exchange rate (and the strength of the pound against the dollar) is going to go down.

Note, this is simplified slightly because we have not taken into account the spread between the bid and ask price.

With this risk management in place, we can make two further comments or observations about the trade.

1) If the trade goes against us, we will be “stopped out” of the trade when the stop loss is hit, causing 2% damage to our account – or $40. In the 1:1.5 example, if the take profit is hit, we gain 3% on the account, or $30.

2) We believe this risk management for forex to be sound. If you use the 1:2 risk reward example, and keep the number of lots traded constant at 0.2 lots, look what happens over ten trades if you are only right about the direction 50% of the time.

The first trade is a loser, the second a winner, the third a winner, the forth a loser, the fifth a loser, the sixth a loser, the seventh a winner, the eighth a winner, the ninth a loser and the tenth a winner as follows.

The first trade is a loser, the second a winner, the third a winner, the forth a loser, the fifth a loser, the sixth a loser, the seventh a winner, the eighth a winner, the ninth a loser and the tenth a winner as follows.

TRADE NO. NET P/L

Trade 1    -40

Trade 2    +60

Trade 3    +60

Trade 4    -40

Trade 5    -40

Trade 6    -40

Trade 7    +60

Trade 8    +60

Trade 9    -40

Trade 10    +60

Total Profit:    +100

In this example, after ten trades, there is still a profit on the starting balance of the account of 0.5%, in spite of only placing trades which turned out to be winners 50% of the time.

The trader therefore needs to focus on getting their winning trade ratio as high as possible and maintaining a highly disciplined approach to forex trading & risk management within that context.

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