Many retail traders focus so much on trying to make money off the market that they often neglect to protect their capital. This causes them to ultimately wipe out their trading accounts no matter how good their ‘money-making’ strategy is.
You see, there are two aspects to profitable trading: increasing your gains, and reducing your losses. Unfortunately the former is the only thing most traders pay attention to. Protecting one’s losses is not as sexy or exciting as making money; and so many amateur traders make the crucial mistake of having a weak money management system in place.
How Much To Risk
When planning out your money management strategy, the first thing you’ll need to decide is how much of your capital you are willing to risk per trade. Experts generally recommend that you risk no more than 2% of your total equity.
An Example
When trading with standard lots, each pip is worth approximately $10.
So let’s say you start trading with $10,000. 2% of $10,000 is $200. That means that you should risk no more than $200 (or 2% of your capital) per trade. And since each pip is worth $10, you can risk a maximum of 20 pips ($200/$10) for each trade that you take. Essentially, this means that you should have a stop-loss of no more than 20 pips away from your entry price.
Does this make sense?
Adjustments Needed
Of course, a 20 pip stop-loss level might be considered too tight for many traders. In reality, it’s up to you to play around with the variables of your money management system. For scalpers for example, a 20 pip stop-loss level might even be too high!
It all boils down to your overall trading strategy… a swing trader will definitely want to use a higher stop-loss allowance, and he can do so by either increasing his equity capital, or by trading using mini lots instead.
The bottom line however, is to never violate the 2%-capital-risk-per-trade rule.
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Harold Hsu is the owner of http://ForexSystemProfits.com where he provides premium Forex trading information and resources.
