Forex margin trading enables the investor to control large amounts of currency with a small capital investment. In order to trade this market successfully, the trader must be equipped with a system of money management. The forex market is a highly volatile market. Large price swings are common within very short time periods. Money management techniques must be used to control risk exposure in forex margin trading.
The use of margin will magnify losses as well as profits. Discretionary or system trading is not advisable without a well thought-out plan for the preservation of capital. The trader might experience a series of losing trades, which is quite common in the forex market. The amount of capital lost is called the drawdown. The maximum drawdown of the account value must be determined before forex margin trading.
Upon opening a forex margin trading account, the broker and trader agree upon the amount of margin to be used. Currency trading offers the highest margin rates available. Novice traders might be attracted to the potential of making large profits with a small capital investment. Without taking forex volatility into consideration, the trader might be risking a large percentage of the account value on a single trade.
The best risk aversion technique is to use a money management plan. The plan should be based on an acceptable risk per trade. Each trade should be given equal weight without exception. All professional traders use a system of money management. Trading without it is no different from gambling.
Even though most brokers offer margin call protection for traders, the amount of loss might exceed the total account value. The money management plan should be developed with the worst possible scenario in mind. System traders should be trading a well-tested system. Back testing should provide the maximum drawdown that a system will experience. The system should be traded under the same market conditions in which it was developed and tested.
Trade size and stop loss orders are determined using the money management system. The maximum loss per trade should be set at no more than about 5 percent of the account value. A value of about 2 percent would be more reasonable. The following example will use the maximum loss per trade set at 5 percent.
With an opening account value of $2,000 US Dollars (USD) the maximum loss per trade would be set at 5 percent, or $100 USD. If the trading system being used requires a stop loss set at 33 pips, then the trade size would be $3 USD per pip. Using this system a losing trade would generate a loss of 33 pips times $3 USD per pip, or a $99 USD loss. The trade size is determined by the maximum loss per trade.
Before entering a trade, it is far more important for the investor to know how much can be lost as opposed to how much can be made. A string of losses is highly probable in forex margin trading. The trader must be prepared to sustain these losses with the ability to continue trading. The only way this is possible is through the use of a money management plan.
Regardless of the margin amount selected by the trader, it is not important if it is not being used. The amount of trading capital used in the above example with a margin rate of 50:1 would be $600 USD to $966 USD, depending on the pair being traded. The above trade would not be possible with a trading account value of $2,000 USD and a margin rate of 10:1. The money management system determines the rules of trading. The margin should be selected to accommodate the money management plan being used.