You must have read Part I of the Money Management Rules article. Failure in investing comes in two forms; Failure to maintain your principle and failure to effectively grow your principle. If you want to become a successful trader, than you need to learn how to grow your principle in the long term.
In case you risk too much, you are going to lose a large percentage of your trading account. Now, you will risk more and try to recover the lost amount and in the end you will lose all your account. There is another form of failure that you should beware of. You were able to grow your account 20% every year. Apparently, you may look like a successful investor. But, if you had a good money management plan with you, you could have made 40% or even more in a year. So what do you say was it your 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 wrong. 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 dealer automatically takes you out of the trade once you have lost $9,000 and only $1000 is remaining. Once you get the margin call, it means you are out of the trade. How could you lose $9,000 in a single trade?
Each pip on a EUR/USD contract is equal to $10. In order to lose $9,000, you need to lose (900*10=9000) 900 pips. Many would say what about the stop loss, dont you need to use it. You are right! You dont need to risk your whole account on a single trade. Never ever trade without a stop loss! You can use stop losses to protect your position as a protection if the trade goes wrong. You could put a 50 pips stop loss losing only $500. You could put a stop loss at 100 pips losing $1000 only.
The amount of money that you set aside with your broker as margin does not tell you anything about the risk unless you plan 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 enjoy the greatest amount of success in their trading are those who have clearly established money management 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 where I explain these three rules in more detail.
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