The 3-Step Approach to Forex Money Management and Risk Control

Forex money management strategy and risk control plan

Creating a Forex money management strategy and risk control plan doesn’t have to be a difficult task.

In fact, it’s one of the easier things you can do to protect your trading capital. Despite this truth, it’s often overcomplicated to the point that most traders fail to create a proper strategy.

This is a huge oversight.

If you don’t have a plan to control risk, sooner or later you’re going to experience a meltdown that could cost you your entire trading account.

Also, the best trading strategy in the world will fail to make you money in the long run without a solid money management plan.

In this lesson, I’m going to show you a simple yet effective 3-step approach to controlling risk and managing your trading capital.

By the time you finish reading this post, you’ll be able to set your risk on a per-trade basis, define a plan of attack for each trade setup and establish limits for yourself to help ensure the longevity of your trading account.

Let’s get to it!

Step 1: Set Your Risk Tolerance

Setting risk tolerance as a traderHow much can you risk per trade without being fearful of losing the entire sum?

That’s the million dollar question. If you can answer that truthfully and combine it with a trading edge, you’ll find yourself on the path to consistent profits in no time.

That may sound lofty, but it’s true. One of the predominant reasons most Forex traders fail is because they risk too much. Traders are historically great at calculating the potential profit on a given setup, but the associated risk is usually an afterthought.

However, it isn’t enough to determine your risk per trade as a simple percentage, although that is half of the formula.

Stating that you will only risk 1% or 2% of your account balance is a common, yet incomplete approach.

Allow me to explain.

If you define your risk per trade as a percentage only, it doesn’t allow your brain to accept the money at risk. Sure, saying you will risk 2% of your account balance sounds logical, but what if that equals $1,000?

If you’re like most people, you felt a stronger emotional attachment to the latter half of that statement.

That’s because a money symbol such as “$” is an emotional trigger and is much more impactful than the percentage symbol as noted above.

What does this have to do with how you define risk?

Everything!

Failing to define a monetary value in addition to a percentage can cost you.

Let’s assume for a moment that you just inherited $100,000 and have decided to deposit half of it into your trading account. You’ve been trading Forex for a few years now and have finally begun to see consistent profits over the last six months.

This is a big moment for you because before the inheritance your account was just $10,000. It has now ballooned to a considerable $60,000.

As part of your Forex money management strategy, you’ve defined your risk per trade as 2% of your account balance. So you had previously been risking about $200 per trade.

See where I’m going with this?

However, after adding the $50,000 to your $10,000 account, your 2% risk has gone from $200 to a not-so-small $1,200.

Are you prepared to lose $1,200 on the next trade?

Probably not.

Of course, you could make the argument that if you had built the $10,000 account up gradually over time, the $1,200 risk wouldn’t seem so daunting.

Perhaps, but there’s a reason why very few professional traders use the traditional 2% rule. It’s because they no longer need to risk that much to make considerable returns. They also know that it paints an incomplete picture of what’s truly at risk.

In summary, it’s important to define your risk on a per trade basis using both a fixed percentage as well as a monetary value. Even if you only write the monetary value next to the percentage, allowing your mind to grasp the magnitude of the associated risk will help you stay in control when you lose.

Step 2: Plan Your Trade and Trade Your Plan

Snapshot of trading journalThe best Forex money management strategy in the world won’t do you any good without a plan for each trade.

But just like controlling risk, your plan for a given trade doesn’t have to be complicated. Simply writing down your exit strategy is enough in most cases.

Your exit strategy should include defining your stop loss level as well as your profit target. And for those who pyramid, be sure to write down the critical levels at which you intend to scale into the position.

Where you keep track of this information is up to you. Daily Price Action members have access to the online trade journal I created for them, but a simple notebook or word processor will do.

Once you have these levels written down, it’s of vital importance that you DO NOT modify them under any circumstances.

Doing so will not only invalidate your plan of attack, but it will also expose you to emotional decision making.

As soon as you put money on the line, you lose the objectivity needed to trade what is happening rather than what you want to happen. In essence, the thought of losing money clouds your judgment.

Step 3: Establish a Pain Threshold

Set a pain threshold for trading ForexNow that you’ve set your risk parameters on a per-trade basis and have a plan of attack for each trade, it’s time to establish a pain threshold.

What is a pain threshold, you ask?

(Don’t worry, it doesn’t require placing a rock on your head to find out)

I define it as the point at which you need an extended break from the market after a string of losses.

For example, let’s assume that you just lost four trades in a row. If you are risking 2% of your account balance on each trade, that amounts to an 8% loss of tradable equity.

(Technically it’s a bit less than 8% on a rolling basis, but we’ll keep things even for example purposes.)

I don’t care how good of a trader you are, that kind of back-to-back loss will rattle your nerves. It can cause you to doubt your abilities, which will inevitably lead to an even greater loss.

It’s a vicious cycle but one that you can avoid with the appropriate limits in place.

Now, let’s assume for a moment that your pain threshold is 10%. That means you can lose a total of 10% of your account balance from peak to trough before you must take a break.

In case you’re wondering, “peak to trough” is simply the change in value from the highest point to the lowest point. So if your account balance recently hit a high of $12,500, a 10% limit means that your threshold would trigger as soon as your account reaches $11,250.

Going back to our example, after four losing trades you’re still technically okay because you’ve lost a total of 8% from peak to trough.

But if you were to lose on the next trade without recouping any previous losses, your pain threshold would take effect and thus require you to take a break from the market.

Whether that break is a couple of days or a couple of weeks is up to you, as long as you return feeling refreshed and without any lingering thoughts of doubt.

Keep in mind that the smaller your risk per trade is that we defined in Step 1, the more wiggle room you’ll have unless of course you also decrease the pain threshold.

This level can vary from trader to trader. However, in my experience, an acceptable range is somewhere between 5% and 10%. This allows you to account for a few consecutive losses, which are inevitable but also prevents you from losing so much that it becomes overly difficult to recover.

Final Words

Developing an effective Forex money management strategy with the proper risk control is a simple process when you know what needs to be defined.

Just like the price action strategies and patterns we trade, the best approach is a simple one. There’s no reason to overcomplicate this task, especially early on in your trading career.

It’s more important to have a plan that you understand and can follow on a daily basis. By keeping it simple and easy to understand, you’re more likely to adhere to the parameters you set.

After all, it isn’t the plan that will make you successful; it’s your ability to follow it.

Your Turn

What’s your strategy for managing money and controlling risk in the Forex market?

Leave your comment or question below and I’ll be sure to respond.

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