Commonly-Held Money Management Myths in Forex Debunked
If we remove all the fancy software and beautified candlestick charts, trading is a business, and businesses exist to make profits. Part of this process is money management, particularly how traders manage their existing capital to benefit from profiting opportunities.
Money management incorporates various techniques in minimizing losses, maximizing gains, and growing trading accounts steadily over time. Yet, as this concept is understandably complex with many subjective philosophies, some myths have become popular.
This article will dispel some of these misconceptions and provide the realistic approaches traders should take instead.
The myth of stop losses
Using a stop loss forms one of the critical components of money management. It’s a fundamental truth that, regardless of skill and experience, every trader will experience a losing position at some point in their careers.
A stop loss has been undeniably proven as the only way to limit losses automatically. However, many promote the idea of not using stop losses. Not using a stop will always leave you at the risk of losing a much larger amount of your funds in one or a few positions.
The other major issue is that you cannot appropriately set a position size, which is another critical part of money management. This is how traders numerically quantify their risk, which involves setting the number of pips for your stop.
You technically haven’t defined your lot size without the latter, meaning it would be somewhat random.
The only time where you might be able to get away without a stop is if you were trading with very tiny lot sizes like 0.01 on each trade and your account was relatively substantial.
Yet, your gains would be comparably small. Every trader is in the markets to their profits while risking the tiniest amount possible. Using a stop loss correctly is the glue allowing for this to happen.
Linked to this myth is that wider stops equal more risk. Traders who hold this belief have not grasped position sizing. Two people can risk $100 using a 10 pip stop or 100 pip stop by adjusting the number of contracts.
After deciding the monetary risk, a trader simply needs to adjust the stop distance accordingly to ensure they don’t go above this limit. Therefore, the width doesn’t necessarily increase the amount at risk.
Every trading opportunity is unique, meaning that you cannot always use the same stop distance each time.
The myth of the fixed percentage per trade
Legendary trader, Larry Hite, was featured in the classic 1989 book ‘Market Wizards’ where he said, “Never risk more than 1% of total equity on any trade.”
This shows us that the popular 1-2% rule has existed for decades and is still often cited in forex-related literature today. The concept itself is not entirely wrong but does have some flaws.
On the positive side, you will stay in the game far longer by ‘risking small.’ No matter how much confidence a trader may have in a setup, the chance of going wrong is always 50-50.
Yet, the fixed percentage model is detrimental when you sustain a series of losses. For instance, if you were risking 2% on a $10 000 account ($200) and your equity dropped to $9 000, that same 2% is now $180.
This means your recovery will take a lot longer. A better approach is using a fixed dollar amount based on a preset percentage of your entire account. So, in the previous example, you may decide to risk $200 each time.
However, this approach would work best with accurate statistics, which account for your worst losing streak over a simulation of hundreds or thousands of trades. Regardless, traders should worry more about the dollars at risk and less about the percentage.
The myth of high leverage
One of the reasons forex is the most traded financial instrument is the high margin. It’s a frequently cited adage that leverage is a double-edged sword in its ability to magnify gains and losses equally.
If you’re using relatively high leverage, there’s a commonly held belief that you are likely to blow your account faster or that one is taking more risk. Most experts recommend traders not to have a ratio above 1:100.
However, this figure is arbitrary because the risk of ruin is technically the same whether your leverage is 1:10, 1:100, or 1:1000.
What matters more, as previously mentioned, is the dollar amount on a per-trade basis. Of course, if your leverage is lower relative to the size of your account, you’d be naturally limited to how much you could trade.
However, you could simply take smaller positions in this case, not trade those lot sizes or deposit more funds. Higher leverage can indeed make an uninformed trader execute an unusually substantial lot size they wouldn’t naturally take otherwise.
Yet, with the correct knowledge of position sizing and thoroughly understanding your bankroll, you will realize the monetary amount is more crucial.
The myth of risk-to-reward ratios not being useful
It’s a universally accepted premise that trading is a game of probabilities. Anyone can buy and sell, but being successful is about consistently looking for opportunities where you reap more from doing this than the amount you’ve risked.
This is where the concept of risk-to-reward (RR) comes in. Profitable traders are only interested in scenarios where the market can regularly net them more pips relative to how much they’ve ‘staked’ on each position.
For this philosophy, we use RR ratios, usually 1:1, 1:2, or higher. This means for every one dollar you put down; you should aim for $1, $2, or higher. The aim is to widen the gap so that every profitable position can easily cover any losses and leave you with a healthy profit.
Therefore, without putting risk to reward at the forefront, you would be essentially trading blindly and taking random positions to be productive. Risk-to-reward is the framework successful traders use to pick only the quality opportunities with the highest chance of tremendously increasing their bottom line.
Any successful trader with a consistent track record will confirm that you should predominantly operate from a defensive standpoint in the markets by protecting your capital as much as possible.
Many traders are guilty of overlooking correct money management, yet it’s arguably the essential quality aside from strong analytical skills.
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