Money management is exactly what you think it means: managing and controlling your deposit. Let’s say for example you have deposited $1000 into a Forex broker, and you load a chart, e.g. GBP/USD. Getting down to business, lets say you’ve applied your system/method, have seen an opportunity to make a profit and you’ve decided to make a trade. So you might want a profit of 50 pips (known as the “take profit” or TP). And the most amount of pips you’re willing to risk is 30 pips (known as the “stop loss” or SL). Your TP is 50 pips, and your SL is 30 pips. This would mean your potential reward is better than your potential risk, which is a very good basis for a system.
So, let’s say you think the GBP/USD is going to move up, and you want to buy that pair, therefore if you went long (i.e. bought) GBP/USD at 1.4421, your TP would be at 1.4471, and your SL would be at 1.4391. So far, so good.
But, the price of GBP/USD might go down, against your anticipated direction, and hit your “Stop Loss” at 1.4391, meaning you’ve just made a loss of 30pips. Or, the GBP/USD might go up, in favour of your anticipated direction, and hit your “Take Profit” at 1.4471, meaning you’ve just made a profit of 50 pips. Of course, you’d have to take the “spread” into consideration (the bit that the broker charges), and on the GBP/USD this is typically 3 pips. So really, you’ve made 47pips profit.
How much money is a pip worth? It depends. Usually, on a standard lot, 1 pip = $10. So if you’ve made 47pips on the GBP/USD on a standard account, you’ve just pocketed $470.
So, wait a second… You had $1000 and you made $470? That’s close to 50% profit in one trade. Ok, so let’s do the math. What if you made 50% each day for a week? Let’s work it out:
Initial deposit/investment - $1k
Monday - $1.5k
Tuesday - $2.3k
Wednesday - $3.4k
Thursday - $5k
Friday - $7.6k
Wow, at the end of the week, your final equity is sitting at a handsome $7600! So after your initial deposit, that’s a pure profit of $6600 in just one trading week! Quite amazing huh......
Ok, hold it there before we all book our luxury holidays. Firstly, it’s unlikely we’ll get 5 winners in a row, and secondly, even if we did, it would be foolish to risk so much per trade. Because remember, if you look at the first trade, if we are aiming for a $470 profit, then it means we’re also risking $300, since if the trade was to go wrong, that’s how much we would lose. Oh dear. And what if we had 2 bad days in a row? That’s a total loss of $600. On a $1000 account! So we’re left with just $400.
There is no guesswork in Forex trading, and there is no risking huge sums of money. Rather, Forex trading is the technical and/or fundamental analysis of a currency pairing, and the application of this specific knowledge.
Concerning the above example, what we would have to do is lessen our risk, by at least ten times. Meaning, on a $1000 account, for that specific GBP/USD trade, we would be going for a profit of $47 with a potential loss of $30. Yes, if you had a $10k account, then by all means you can trade higher “lots”. The number of lots is how you determine the amount of money you’re willing to gain or lose.
Remember, money management is related to your deposit/equity. The best way to calculate your risk (i.e. Stop Loss), is to decide how much you’re willing to lose on any given trade, in terms of percentage. So if you’re prepared to lose 1% on your account, then it means the most you can lose on any trade on a $1k account is $10, which is much more bearable. Likewise, on a $15k account, if you risked 1% on a trade, then the most you could lose on that trade is $150, which is totally reasonable. Again, everything is relative.