Have you ever played poker? If you have, then rarely you will see good players put all their chips on a single bet. As a poker player, you know by risking only a small portion of your money on a single bet, you can win or lose but be still play the next hand. If you put everything on the table on a single bet, you have to be 100% sure of winning. An impossible thing, you can never be 100% right.
You must know that currency trading is far more complicated than playing poker. You will be dealing with hundreds and hundreds of unknown variables that affect the markets what to talk of only 52 cards. You must understand and implement good money management principles in order to succeed at forex trading.
You can fall into many pitfalls while trading. As a trader you should be constantly guard against two emotions. Greed and fear! In case you are on a winning streak, you will become greedy. You would want to risk more to make one big win and you would want to strike it rich in one or two big trades. This will make you risk more and more of your money on a single big trade.
When you lose a trade, you become afraid to risk enough of your money on the next trade. Fear takes over and impairs your decision making, making you lose confidence in your judgment and decision making. Lets see how fear and greed can play havoc with your trading.
Lets suppose you have a run of successful trades that makes you very happy. You are feeling overconfident. You are not satisfied on risking only 2% of your account on one single trade and you want to risk more on the trade. You are thinking, the more you have in a trade, the more you will make if you are right. You are willing to increase your risk to 5%. You increase it to 5% and you win. You increase it further to 10% and you once again win. You finally decide to put 25% of your account at risk on the next big trade, but misfortune strikes all of a sudden. Your successful run comes to an end and you lose big.
Suppose you had a $100,000 trading account and you had foolishly risked 25% or $25,000 on one trade that you desperately wanted to win. Losing $25,000 means you have only $75,000 in your account now after your loss. How much you need to make to get back the original balance of $100,000; you need to make $25,000 again to go back to the original balance. It means you will have to make 25,000/75,000= 33%, so you risked 25% but now you will need to make 33% to get back your original amount.
Many investors once they lose a trade become desperate and try to risk more to recover their original loss. They end up losing more and more and very soon those investors destroy their accounts. Most of them are out of trading forever soon. There are other traders who try to reduce risk even more on making a losing trade; eventually they lose any opportunity for meaningful growth in their accounts.
[...] Management Rules (Part II) You must read Money Management Rules (Part I) before you start reading this article. Failure in investing can come in two forms. One is failure [...]