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  • Intro
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  • Japanese Candlesticks Theory
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  • What is Forex and How Does It Work?
  • Introduction to Charting
  • Introduction to Technical Analysis
  • Risks
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  • Introduction to Fundamental Analysis
  • Gold and Silver
  • Money Management
  • Position Sizing
  • Understanding and Trading the News
  • Earning Interest in Forex
  • Introduction to Fibonacci Analysis
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• Glossary

Money Management

Risk, Consistency and Diversification

A common mistake of forex traders is failure to understand, accept and manage risk. These are principles applied to investing in the forex market in general, as well as in each trade.

Once risk is assessed, you can use consistency and diversification to smooth returns and control risk.

Risk per Trade

This can be a simple or complicated problem, depending on your trading strategy and positions. Most commonly, the risk you are exposed to per trade is your stop loss, plus trading costs. Without a stop-loss, your risk is theoretically infinite. Add transaction costs and slippage to the stop-loss, and you have total risk.

Once you know what your risk is per trade you need to determine whether this is an acceptable portion of your total account value. Risking too much in a single trade will be disruptive to you emotionally and that leads to bad decision making. Many traders start by only risking 2-3% of their total portfolio per trade and may work up over time depending on their risk tolerance and comfort level.

Everyone will have some losing trades. The key is keeping them small and infrequent as compared to your gains.

How much to risk in a single position is a function of the total capital you want to use for a given trade, and your risk tolerance (the maximum loss that is tolerable for you).

But the most important factor in evaluating each trade is consistency. Randomly selecting the amount you will invest in a trade creates inconsistent results and will negatively impact returns. At that point, you have no strategy, just random gambles.

The images below are good illustrations of what happens to a trading strategy when you change your variables frequently. This strategy was back-tested with two different position sizing strategies, one that was constant, and one that was changing.



The system above returned 1,347 pips over the testing period and had a constant tolerable risk.

This was the exact same system, over a similar period of time, but with a randomly selected tolerable loss and position size. The inconsistency created volatility in the account, which ultimately made it impossible to make up larger losses with smaller winners.

The forex has many nuances like heavy leverage and unique margin. A lack of understanding of these factors has caused many a new forex trader to lose their entire trading account.

Building solid rules, and managing consistent trading methods are key in this market.


Forex Portfolio Diversification

There are two ways to look at asset allocation (the way you divide your investments) and diversification as it relates to the forex: Diversifying within the forex and diversifying in other markets.


Diversification within your forex trades

You should be creating variety in the way that you trade or invest within the forex. For example, if you are managing your positions one trade at a time, or with only a single strategy, you are exposing yourself to focused risks without any way to offset them. This creates volatility within your account, and account volatility can disrupt your trading mentality and lead to losses.

While investing in one trade at a time is where a lot of new traders will start, doing so long-term will inadvertently expose you to a very concentrated level of systemic risk. Keep in mind that it is a common mistake to "diversify" into other pairs that are similar. For example, being long the EUR/USD and short the USD/CHF is in many ways the same trade because the EUR and CHF are highly correlated and in both cases you are short the USD. The crosses can be very helpful when you are trying to make sure you are diversified across other currency pairs.


Diversification into other markets

The smartest traders are not exclusively invested in just one asset class like forex, stocks, bonds or futures. Being solely invested in the forex, or stocks, or bonds leaves you exposed to systemic risk. Systemic risk is the type of risk that you can’t get rid of and usually involves catastrophic volatility in a particular market because of an unexpected unknown.

The benefit is that when one market is not performing well, another market may be doing much better, and the combined return is much smoother. For example, owning or trading bonds while some of your money is in the forex and/or equities can smooth your overall returns.

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