Saturday, July 4, 2009

The 3 Basic Fundamentals of Money Management

Money management is a part of investment management that teaches us how much risk an investor can and should take up. Money management in some form or the other is also referred to as the asset allocation, portfolio allocation, trade management, position management and size management. In Forex trading, money management requires trade planning, which helps in cutting losses and preserving capital.
The following are the key guidelines for money management which can help an investor in allocating their funds wisely, in turn helping them with greater capital appreciation.
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Good money management starts with good planning and planning starts with the setting up of specific financial goals. Set long terms goals for your financial needs in terms of retirement, education, children, etc., and see how forex trading fits in. Ideally, forex trading shouldn't be a whimsical reaction to a night of binge drinking, so to speak!
The second guideline for money management, as experts suggest, is that the total investment of funds should at any time, be no more than 50% of the total capital available to an investor . The other half of the available funds should be kept in reserve, in case of any market downturn or adverse direction.
Another critical aspect of money management is never to put all your eggs in one basket- often tempted by potentially large gains, novice investors will dump a large sum of money in a single Forex contract. This, while offers a potentially large gain, can also mean the end of your entire life's hard earned savings. Again, having a trading plan with clear risk tolerance metrics is critical. Experts suggest that the total investment in any pair should be limited to 10-15%, of the total portfolio.
The amount of risk in any trade should be limited to no more than 2% of the total invested capital. This is essentially a cap on how much risk or loss a trader is willing to bear, if there is any downturn or adversity in the market.
A trader should not invest capital in just a single pair, but ideally in multiple pairs, to achieve the benefits of diversification. For instance, take EUR/USD, USD/JPY, and AUD/CAD. Rather than putting all the money in one pair, traders can make portfolio of different pairs, according to their choices (based on research) and can take long or short positions.
2 contract - Long Position in EUR/USD.2 contract - Short Position in USD/JPY.2 contract - Long Position in AUD/CAD.
The given guidelines are essentially just that- guidelines! They cannot be thought of as strict rules. For instance, based on one's own preferences, a Forex trader may choose to invest up to 20% in a single contract. However, these guidelines on money management can be a critical asset for novice and expert traders alike, in helping them create a sensible trading system, set limits on their trading, make realistic trading goals and earn profits through intelligent Forex trading.
Key Takeaways
The recipe for success in FX trading: Sound entry/exit strategy, money management and emotional control. Don't put all your money in one market or one trade, design a portfolio and set goals. Remember, diversification is the key to effective portfolio returns while trading Forex!

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