To craft a consistent, conservative FOREX trading strategy, put more emphasis on money management than on selecting entry points or profit targets. The biggest mistake made by FOREX traders is over-use of leverage; this results in putting too much of the account at risk on each trade. Other key factors include having a clear, consistent plan for each trade, and having the discipline to follow that plan.
Leverage sets FOREX apart from most other trading vehicles. Depending on your FOREX broker, you can employ leverage of 100:1 or more. In a EUR/USD trade at 100:1, $10,000 can control one million dollars worth of euros. A change of 1/10 of a cent in the exchange rate changes your account balance by $1,000. That is the powerful effect of leverage.
In chapter seven of his book "Come into My Trading Room," Dr. Alexander Elder recommends that you limit the loss on any individual trade to no more than 2 percent of your total trading equity. Using the above example and assuming trading equity of $50,000, you must be prepared to exit a EUR/USD trade if it moves against you just 1/10 of a cent (only 10 "pips," aka "points").
Any conservative FOREX trading plan requires allowing a EUR/USD trade to move against you more than 10 pips before you exit the trade. To do so, simply reduce leverage. Allocate $10,000 to the trade, but buy or sell only $100,000 worth of euros. You effectively reduce leverage to 10:1. A $1,000 loss (2 percent of $50,000) is not realized unless the exchange rate goes against you by one cent (100 pips).
To further clarify the effect of leverage on money management, let's say you are just getting started and have a micro account with $5,000 total trade equity. Allocate $1,000 to the EUR/USD trade but buy only $5,000 worth of euros (5:1 leverage). This allows you to risk 100 pips while limiting your loss to $50, or just 1 percent of trade equity. As you gain experience and confidence in your trading system, ramp up the leverage ratio. Be advised that experienced institutional traders rarely go beyond 20:1.
Have a Plan
Take time to thoroughly test your trading plan before risking real money. Use a broker who allows you to trade with play money, using the same trading platform used for real money trades.
Learn how to enter orders and how news events affect your plan. Test the plan on various currency pairs, at different times of day, and under different market conditions. Your plan must have well defined, unambiguous entry and exit points. You must have the discipline to enter and exit every trade following the rules of the plan. Paired with conservative money management, this strategy can lead to consistent results.
The FOREX market is among the riskiest, especially when leverage is misused. Most traders lose their trading equity. Never trade with funds you can't afford to lose.
- Come into My Trading Room; Dr. Alexander Elder; 2002
- NASDAQ.com: FOREX Leverage