Money Management: Let Your Profits Run / Cut Your Losses
One of the old sayings in trading is to let your profits run and cut your losses. Easier said than done, right? In theory, the overall principle is a sound one: It leads to disciplined trading and the account growing. In reality, though, it is not that easy. Forex markets are known for the fake moves that are happening all the time. Therefore, if one cuts the losses on a fake move, he/she will end up buying/selling the same pair once again after the move has been proven to be a fake one. Nevertheless, the overall principle is a solid one, and it deserves a mention here on the Forex Trading Academy. What we should also do is to highlight the good and bad things about this principle, and what the best approach to trading the Forex market is.
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Money Management Principles
Money management deals with traders following a set of rules designed to protect their trading accounts from losses. Without a proper money management system, success in trading is almost impossible. Such a system takes into account losses as well as gains. If one is trading with the idea that losses can never occur, then the battle is lost before the start. The idea is to find a way to navigate through good and bad trades in such a way that over time the trading account grows. The main point is (or should be) that the account should grow over time. In trading, as in life, there are good and bad periods, as nothing moves in only one direction. Sometimes there are things that affect traders – outside things – and this will be seen in the trading account. In theory, it is very simple: Stay focused and follow the trading system. The reality is different, though, and this has much to do with the human nature we’re bound to respect.
Let Your Profits Run.
To let your profits run means to stay for the take profit, or for the target initially set. This, again, is a sound principle, but in Forex trading it is not necessarily the best one. It all depends on the trading style. One of our previous articles here on the Forex Trading Academy deals with the different trading styles, and how the approach is different based on different time horizons. Letting your profits run does not apply to scalpers or investors, but to swing traders. A swing trader is a trader who has a time horizon for trades anywhere between 1 day and a few weeks, as the timeframes analysed are up to the weekly charts. Even if longer timeframes are used, such as with the monthly chart or historical data approach, it is a top-down analysis that is involved, and the swing trading principle is not affected. To let your profits run means to respect the risk/reward ratio. We know by now that such a realistic risk/reward ratio for the Forex market is 1:2 or 1:2.5 . This means that for every pip risked, traders are looking to gain at least 2 or 2.5 . This is a tricky statement, though: What do you do when the price moves extremely close to your target, but yet does not reach it? Are you still going to let the profits run with the cost of price reversing?
There is a saying that sometimes the last pips are the most expensive ones, and this cannot be truer than in the risk/reward ratio. However, as unrealistic as it may be, the thing to do is to follow the rules blindly. It may be that sometimes the market turns just before reaching the take profit, and the turn is so bad that it is going to hit the stop loss. This doesn’t mean anything except that the analysis was wrong in the first place, and the trade was doomed to failure.
Cut Your Losses.
If letting your profits run is one thing, cutting your losses is another. This is the most difficult thing to do in trading, and there are very few people who respect this principle. This is why the percentage of winning traders is so small. Traders are not cutting losses when they should be cut! There are many reasons for this, but again, human nature dominates this chapter too. Because Forex is full of fake moves, there’s always the belief that “the market” is going against you. No matter what, the market is going for your stop, and by the time it is reached, the trend has reversed. How many times did you see that happening? I can tell right now that this has happened many times for every trader, and when things go really bad the tendency is to remove the stop loss or to widen it. This is a crucial mistake. It could be that the trader thinks there is enough capital in the trading account, but the main idea is that no matter what the reasoning, failure to cut your losses or to stick to the original trading plan is wrong, and will lead to further losses. Indeed, it will possibly lead to losing the trading account! The purpose of this article is to pinpoint the importance of money management, and why sticking to your trading plan pays off in the long run. After all, what is the purpose of having a trading plan if you’re not able to follow it?
Other educational materials
- How to Use Parabolic SAR to Buy Dips or Sell Spikes
- Bollinger Bands – Profit from One of the Best Trend Indicators
- Geopolitical Risks That Influence Markets
- Different Trading Styles
- Dynamic Support and Resistance Levels in Forex Trading
- A Guide for Trading Rising and Falling Wedges
Recommended further readings
- “Discipline and Risk Control.” Robbins, Robert. In Tactical Trend Trading, pp. 133-146. Apress, 2012.
- “Effect of market organization on competitive equilibrium.” Smith, Vernon L. The Quarterly Journal of Economics (1964): 182-201.