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 to maintain your principle. Most investors fail because they lose their principle too soon. The second failure is to effectively grow your principle. If you want to become a successful currency trader, you should learn how to protect and how to grow your principle in the long run.
If you risk too much, you lose a large portion of your account. Risk more to try to recover the lost amount and lose all your account. There is another form of failure. You are able to grow your account 20% annually. On the surface, you may be a successful investor. But, if you had a good money management plan you could have made 40% annually. So was it a success or failure.
You should know before each trade how much is truly at risk in a single trade? Many traders misunderstand this and dont know their risk. Suppose you have a $10,000 account and you buy one lot of EUR/USD. Your forex broker will set aside $1,000 in your account as a margin, so how much of your money is at risk? Many would say only $1000 but they are wrong. You have $9,000 to trade, $1000 was for margin. So your risk is $9,000 and you could lose up to this much before you receive a margin call from your broker.
A margin call is an order when your forex broker automatically takes you out of the trade once you have lost all but the last $1000. Once you get the margin call, it means you are out of the trade and have lost $9,000 in your trading. How could you lose $9,000 in a single trade?
Each pip on a EUR/USD contract costs $10. So if you lose 900 pips (900*10=9000), you have lost $9,000. Many would say where the stop loss is. You are right; you dont need to risk your whole account on a single trade. You can use stop losses to protect your position. You could place a stop loss at 100 pips losing $1000 only or 50 pips losing only $500.
No matter where you set the stop loss, the amount of money that you set aside with your broker as margin does not tell you anything about the risk unless you plan to get a margin call. Understand these common money management pitfalls. Until and unless, you do not develop your own money management rules, you will most likely slip into one or more of these pitfalls.
Investors who enjoy the greatest amount of success in their trading are those who have clearly established money management rules that govern their trading. Those rules are; 1) Live to trade another day, 2) Knowing how much to risk and 3) Knowing how to determine the trade size. You should read Part III of this article where I explain these three rules in more detail.
About the Author Ahmad Hassam
Mr. Ahmad Hassam is a Harvard University Graduate. He is interested in day trading and swing trading stocks and currencies. Learn Forex Nitty Gritty. Discover A Revolutionary New Forex Robot. Try Netpicks Forex Signal Service.