T2. Not Having a Money Management Game Plan
I am constantly amazed at the number of Forex traders and brokers that have no concept of ‘money management.’ Money management is controlling risk through the use of protective stops or hedging, while balancing the potential for profit against the potential for loss.
Here is an example of poor money management that I see almost daily... many traders refer to a trade that might lose $500 if they are wrong and make $1,000 if they are right as a two-to-one risk/reward ratio. This is usually considered a “decent” trade. What is wrong is that it is just as important to know the proper win/loss ratio as knowing how much you are going to lose if you are wrong and how much you are going to make if you are right, but what are the odds of making money... of being right? What are your odds of losing money, or being wrong?
Good money management means knowing a trade’s profit objective and the odds of being right or wrong and controlling the risk with protective stops. You are better off with a trade where you might lose $1,000 if you are wrong and make $500 if you are right, if the trade works eight times out of ten, than to take a trade where you make $1,000 if you are right and lose only $500 if you are wrong, but the trade works only one time out of three. Developing and testing money management concepts is the way to overcome this problem. An entire book could be written on money management principles, but the key is to know your win percentages along with proper risk/reward ratios.
This mistake fits right in with the lack of a trade plan and money management. It is the failure to use protective stop orders once you enter a trade – not mental stops, but real stops that cannot be removed. All too often, Forex traders use mental stops because they have been stopped out in the past and subsequently watched as the market moved in their direction. This does not invalidate the use of pro tective stops – it means that the stop was most likely in the wrong place, as it was likely not a good technical stop. When a protective stop that was determined before a trade was entered is hit, it means the technical analysis was probably incorrect... your trade plan was wrong.
With a mental stop, as soon as the market has gone through the protective stop price, you no longer act like a rational human being. Now, you are likely to make decisions based on fear, greed and hope. How many times have you had a mental stop and tried to make a decision whether or not to take a loss? Typically, by the time the decision is made and acted upon, the market has run further against you. Invariably, you decide to hold onto the trade hoping that you can get out on a Fibonacci retracement to your previous stop price.
Unfortunately in many cases, it never touches that price again and you end up taking a large loss. Or, you
make the mistake of holding the trade an extra day because you hope the market moves higher the next day. But the next day, the market is lower yet and by then the loss is so large you cannot “afford” to get out of the position – and what should have been a small loss turns into a disastrous loss.
There is an old saying that ‘the first loss is the smallest.’ It is also the easiest to take, even though it may seem hard at the time. The only way to overcome this mistake is to have an unbreakable rule with the discipline to follow it that a protective stop loss order or hedge must be placed on every trade.
I have found the easiest way to take a loss is to place the protective stop order or hedge limit order the moment or immediately after entering the trade. Do your homework when the markets are slow. Place your
orders while the market is still quiet. Another rule to follow – under no circumstances should an initial protective stop order be changed to increase the risk on a trade, but only to reduce it.
Continued : Not using protective stop loss orders
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