Money management with a small Forex account
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You cannot succeed in the financial markets if you do not apply strict money management. The problem with Forex trading is that the minimum position size is 0.01 lot, or 1000 units.If your upfront investment is too low, you have to use leverage on each of your positions. That can become significant if you repeat it over and over again, the greater the leverage effect, the greater the risk.But then, can you effectively manage your risk if you have too small a Forex account? I'm talking about traders whose upfront investment is less than €1,000.
To manage your risk effectively, you need to be able to adjust the size of your positions on each trade. For a trader with a small Forex account, the question doesn't arise, he always has to deal with the lowest position amount, i.e. 0.01 (1000 units), which are called mini lots.
On EUR/USD, 1 pip is worth $0.1 (the capital gain or loss generated by a trade is always expressed in the counter currency - right-hand currency - to be converted back into the base currency of your trading account), i.e. €0.08 (0.1/1.24 - 1.24 being the current EUR/USD rate).
Let's see what margin you have before levelling your account by dealing with mini lots (0.01).
- €1,000 account:1000/0.08 = 12,500 pips
- €500 account:500/0.08 = 6250 pips
- €200 account: 200/0.08 = 2500 pips
Even for the smallest account, a trade on EUR/USD with a stop loss at 50 pips of your entry price, the risk on the position is €4 (50*0.08), or 2%.With a €500 account, this falls to 0.8%, and to 0.4% on a €1,000 account.
Money management rules require you not to exceed 2% risk per position, and that's a maximum. For beginners, it is better to apply 1%.For those with an account under €400, it is therefore impossible to comply with the money management rules in this example.
Let's now assume that you see a long-term buying opportunity on EUR/USD on a daily chart. On this type of time unit, the stop loss often exceeds one hundred pips.Let's take the case of a stop at 150 pips, 3x more than in the previous example, i.e. a risk of €12 (150 * 0.08).Here is the percentage risk based on the size of your account:
- €1,000 account: 12/1000*100 = 1.2%
- €500 account:12/500*100 = 2.4%.
- €200 account (already eliminated):12/200*100 = 6%.
On a long-term position, only the €1,000 account manages to have a risk worth having which complies with money management rules.
To comply with money management rules, you must therefore reduce your risk. But how do I do that?Two solutions:
- Deal over small units of time: Since you can't play on the position size to manage your risk, you must reduce the gap between your stop loss and your entry price.A stop loss is placed according to a market level and nothing else should influence it. To reduce the gap, the only solution is to deal over small time units. The smaller the time unit, the closer your stop loss will be in terms of pips and the lower your risk will be. (This is what we looked at in the two examples above)
If you are trading on units of time close to 1hr, the stop loss is a few dozen pips away. On the other hand, you should not deal over 4 hours, daily, weekly or monthly. This is constraining but it is important to know that there is no link between the unit of time used and the performance generated.A 15-minute trader can actually generate a higher performance than a daily trader.
- Reduce the number of simultaneous positions: You need to pay very close attention to the signals of your trading strategy so that you don't have too much overall risk.Indeed, respecting the max risk per position is fine but if you take several positions at the same time, you will risk too much of your capital at once. It is indeed necessary to consider the scenario where everything goes wrong and where all your trades go in the wrong direction... (it happens!!). Money management is also about setting yourself a maximum loss threshold per day. Generally, it should correspond to twice the average daily gain.If you exceed this threshold, in case of loss, making up for your loss will seem impossible and you will act irrationally (increase the lever, no more stop loss, take position without a signal, etc.).
Yes! Money management isn't there just to look good.9/10 of traders lose out on Forex... Why? The losses are often due to traders not cutting their losing positions. Traders won't accept losing and don't place a stop loss or they place a stop loss with too large a margin.
The study also shows that traders cut their gains too quickly. On each currency pair, the average gain is less than the average loss in pips. Yet 50% of trades make money.The risk/return ratio is therefore not respected.
Finally, the study shows that the majority of losing traders with an account of less than €1,000 use a leverage higher than 1:26. Worse still, we can even see that among the winning traders, the use of a leverage effect greater than 5 reduces their performance.
Non-compliance with money management rules therefore inevitably leads to a loss of all your capital.
The psychological aspect of trading must also be taken into account.If you suffer too much loss (due to too much risk-taking), you will often become irrational in your choices. Don't underestimate the power that money has over you. (See article: Psychology: the trader's enemy)
With a trading strategy, it is generally advisable to have an equivalent risk on each position.If this is not the case, some trades will have a greater impact on the performance of your trading account.Everything will depend on the spacing of your stop and your objective.
Since you can't play on the size of the position to adjust your risk on each trade, trades with a greater stop spacing in terms of pips (and therefore an objective also further away) will strongly influence your performance.
Let's take the example of one EUR/GBP trade, another EUR/USD trade, and one EUR/JPY trade. On a 1hr time unit, a stop on EUR/GBP is for example 20 pips, on EUR/USD 35 pips and on EUR/JPY 60 pips. Effectively, the spread of the stop depends on the quotation value of the pair and its volatility.
A losing trade on EUR/JPY will therefore cost you twice as much as a losing trade on EUR/GBP.
It is better to succeed in significant trades in these conditions. To deal with this, the only solution is to test your strategy on a single pair or find pairs that are about the same in terms of value and volatility.
Don't forget that a first deposit is made to test your trading strategy in real conditions (with your money in play) but it is above all a way to test your psychology. Are you able to manage stress? Can you follow your trading plan to the letter even in case of loss? Will you succumb to the temptation of leverage?
Testing a trading strategy should be carried out on a demo account, not a live account! Before opening a live trading account, you should have passed through a demo account (see the article, the value of a demo account on Forex).
Below €500, I strongly advise against depositing on Forex.Between €500 and €1,000, it is possible to comply with money management rules but at the price of certain constraints in your trading.It is an excellent test for testing your psychology and to find out if you are able to impose strict rules.If you pass this step successfully, you can deposit more and start to contemplate gains with Forex.
What is the minimum deposit amount required to comply with money management rules?
To manage your risk effectively, you need to be able to adjust the size of your positions on each trade. For a trader with a small Forex account, the question doesn't arise, he always has to deal with the lowest position amount, i.e. 0.01 (1000 units), which are called mini lots.
On EUR/USD, 1 pip is worth $0.1 (the capital gain or loss generated by a trade is always expressed in the counter currency - right-hand currency - to be converted back into the base currency of your trading account), i.e. €0.08 (0.1/1.24 - 1.24 being the current EUR/USD rate).
Let's see what margin you have before levelling your account by dealing with mini lots (0.01).
- €1,000 account:1000/0.08 = 12,500 pips
- €500 account:500/0.08 = 6250 pips
- €200 account: 200/0.08 = 2500 pips
Even for the smallest account, a trade on EUR/USD with a stop loss at 50 pips of your entry price, the risk on the position is €4 (50*0.08), or 2%.With a €500 account, this falls to 0.8%, and to 0.4% on a €1,000 account.
Money management rules require you not to exceed 2% risk per position, and that's a maximum. For beginners, it is better to apply 1%.For those with an account under €400, it is therefore impossible to comply with the money management rules in this example.
Let's now assume that you see a long-term buying opportunity on EUR/USD on a daily chart. On this type of time unit, the stop loss often exceeds one hundred pips.Let's take the case of a stop at 150 pips, 3x more than in the previous example, i.e. a risk of €12 (150 * 0.08).Here is the percentage risk based on the size of your account:
- €1,000 account: 12/1000*100 = 1.2%
- €500 account:12/500*100 = 2.4%.
- €200 account (already eliminated):12/200*100 = 6%.
On a long-term position, only the €1,000 account manages to have a risk worth having which complies with money management rules.
How can I reduce my risk to comply with money management rules?
To comply with money management rules, you must therefore reduce your risk. But how do I do that?Two solutions:
- Deal over small units of time: Since you can't play on the position size to manage your risk, you must reduce the gap between your stop loss and your entry price.A stop loss is placed according to a market level and nothing else should influence it. To reduce the gap, the only solution is to deal over small time units. The smaller the time unit, the closer your stop loss will be in terms of pips and the lower your risk will be. (This is what we looked at in the two examples above)
If you are trading on units of time close to 1hr, the stop loss is a few dozen pips away. On the other hand, you should not deal over 4 hours, daily, weekly or monthly. This is constraining but it is important to know that there is no link between the unit of time used and the performance generated.A 15-minute trader can actually generate a higher performance than a daily trader.
- Reduce the number of simultaneous positions: You need to pay very close attention to the signals of your trading strategy so that you don't have too much overall risk.Indeed, respecting the max risk per position is fine but if you take several positions at the same time, you will risk too much of your capital at once. It is indeed necessary to consider the scenario where everything goes wrong and where all your trades go in the wrong direction... (it happens!!). Money management is also about setting yourself a maximum loss threshold per day. Generally, it should correspond to twice the average daily gain.If you exceed this threshold, in case of loss, making up for your loss will seem impossible and you will act irrationally (increase the lever, no more stop loss, take position without a signal, etc.).
Do I have to follow the rules of money management?
Yes! Money management isn't there just to look good.9/10 of traders lose out on Forex... Why? The losses are often due to traders not cutting their losing positions. Traders won't accept losing and don't place a stop loss or they place a stop loss with too large a margin.
The study also shows that traders cut their gains too quickly. On each currency pair, the average gain is less than the average loss in pips. Yet 50% of trades make money.The risk/return ratio is therefore not respected.
Finally, the study shows that the majority of losing traders with an account of less than €1,000 use a leverage higher than 1:26. Worse still, we can even see that among the winning traders, the use of a leverage effect greater than 5 reduces their performance.
Non-compliance with money management rules therefore inevitably leads to a loss of all your capital.
The psychological aspect of trading must also be taken into account.If you suffer too much loss (due to too much risk-taking), you will often become irrational in your choices. Don't underestimate the power that money has over you. (See article: Psychology: the trader's enemy)
Another problem with small trading accounts
With a trading strategy, it is generally advisable to have an equivalent risk on each position.If this is not the case, some trades will have a greater impact on the performance of your trading account.Everything will depend on the spacing of your stop and your objective.
Since you can't play on the size of the position to adjust your risk on each trade, trades with a greater stop spacing in terms of pips (and therefore an objective also further away) will strongly influence your performance.
Let's take the example of one EUR/GBP trade, another EUR/USD trade, and one EUR/JPY trade. On a 1hr time unit, a stop on EUR/GBP is for example 20 pips, on EUR/USD 35 pips and on EUR/JPY 60 pips. Effectively, the spread of the stop depends on the quotation value of the pair and its volatility.
A losing trade on EUR/JPY will therefore cost you twice as much as a losing trade on EUR/GBP.
It is better to succeed in significant trades in these conditions. To deal with this, the only solution is to test your strategy on a single pair or find pairs that are about the same in terms of value and volatility.
Don't forget that a first deposit is made to test your trading strategy in real conditions (with your money in play) but it is above all a way to test your psychology. Are you able to manage stress? Can you follow your trading plan to the letter even in case of loss? Will you succumb to the temptation of leverage?
Testing a trading strategy should be carried out on a demo account, not a live account! Before opening a live trading account, you should have passed through a demo account (see the article, the value of a demo account on Forex).
Conclusion
Below €500, I strongly advise against depositing on Forex.Between €500 and €1,000, it is possible to comply with money management rules but at the price of certain constraints in your trading.It is an excellent test for testing your psychology and to find out if you are able to impose strict rules.If you pass this step successfully, you can deposit more and start to contemplate gains with Forex.
