You must read Part I of the Money Management Rules before reading this article. Failure in investing can come in two forms. One is failure to maintain your principle. The second is failure to effectively grow your principle. If you want to become a successful forex trader, you should learn how to grow your principle in the long run.
In case you risk too much, you are going to lose a large part of your account. You will risk more and try to recover the lost amount. You will lose all your account. There is another form of failure that you should know. You are able to grow your account 20% every year. On the surface, you may appear to be a successful investor. But, if you had made a excellent money management plot, you could have made 40% in a year. So what do you say was it a success or failure?
You should know before placing each trade how much is really at risk in a single trade? Many traders misunderstand this and dont know what their risk is. Suppose you have a $10,000 account and you buy one lot of EUR/USD contract meaning $100,000. Your forex broker will set aside $1,000 in your account as a margin or guarantee, so how much of your money is at risk? Many would say only $1000 but they are terribly incorrect. You have $9,000 left to trade, $1000 was for guarantee. So your risk is $9,000. You can lose up to this much if you are not careful before you receive a margin call from your broker.
A margin call is an order when your broker automatically takes you out of the trade because you have no more money left in your account. Once you get the margin call, it means you are out of the trade and have only $1000 left in your account. So how could you lose $9,000 in a trade?
Each pip on a EUR/USD contract costs $10. So if you lose 900 pips (900*10=9000), you have lost $9,000. Many would say where the stop loss is. You are right; you dont need to risk your whole account on a single trade. You can use stop losses to protect your position. You could place a stop loss at 100 pips losing $1000 only or 50 pips losing only $500.
The amount of money that you set aside with your broker as margin does not tell you anything about the risk unless you plot to get a margin call. Understanding these common money management pitfalls will help you a lot and make you a successful trader in the long run. Unless and until, you do not develop your own money management rules, you will fall into one or more of these pitfalls.
Investors who delight in the greatest amount of success in their forex trading are those who have clearly established rules that govern their trading. Those rules are; 1) Live to trade another day, 2) Knowing how much to risk and 3) Knowing how to determine the trade size. You should read Part III of this article to know more on these rules.