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Prudent Capitalization

There is no doubt that forex can be exciting. A $4 trillion per day, 24 hour market with numerous pairs gyrating up and down in random and rhythmic motions in an endless, tantalizing dance before our eyes. Each pair has a kind of energy and beauty of its own, making teasing moves up and down, wanting us to bet more and more of our money to grab its pips. Its seems so easy. We read everywhere how people are making millions in forex. We also read how it takes money to make money. Ergo, we just need to put a good part of our savings in a forex brokerage account, purchase the latest and greatest indicator or expert advisor, and we will be flooded with pips and profits. If only things are were so easy....

A word of warning: FOREX IS AN EXCITING YET DANGEROUS WORLD!

What seems so easy is in fact extremely difficult. 
What seems to give you endless pips and profits will quickly diminish your account in staggering losses. 

It is thus that we have to figure out the proper rules of money management, and the first rule of money management is figure out how much we should prudently invest.

To this end we have to avoid the twin dangers of over-capitalization and under-capitalization.

Over-capitalization: Never Bet the Farm

All trading, in every market, involves a high level of risk with no certain outcome, and one should never trade with more than they can afford to lose. The explosion of hype in the forex market regarding the latest "Holy Grail" robotic system or signal service that can guarantee quick and extraordinary returns has tempted many people into rushing into forex with money they cannot afford to lose. I have met people who have quit their jobs to become "forex traders" with their $6000 savings account, hoping to living off the 30% monthly return they are expecting from their trading. Needless to say, in striving for an impossible return, they over-leverage and over-trade their account into oblivion within a couple months. 

If you are new to trading, and you do have money, you should avoid the temptation of over-capitalizing your account. You might not be so foolish to bet the farm, but you might be foolish enough to invest more than you should. As we have seen in the previous article, forex is a highly dangerous arena with the odds stacked against you from the onset due to transaction costs and your competition being vastly superior and more sophisticated. Moreover, there is a high degree of randomness and sharp vacillations in the market that make it extremely difficult even for the professional traders to survive, and near impossible for the newbie. 

In fact, if you do not have adequate knowledge, experience, control over your emotions, a strong trading plan and cutting edge system, you have a 90% chance of consistently losing forex.

My own forays in the realm of forex have taught me to not keep too much money in your account. Imagine, for example, that you have to do a little shopping at the super market, and you walk in the store with $500 in your pocket. What are the chances you spend a lot more, making impulsive acquisitions, of things that you really don’t need when you have a pocket full of money? It is the same with trading. Too much money leads to excessive careless trading.

Undercapitalization: Trading on Thin Ice

Many businesses fail due to undercapitalization, and this holds true for Forex as well. Many retail brokers offer minimum account deposits as low as $1 or $25, but it would be foolish to trade with the minimum. One adverse trade would cause a margin call and force you to liquidate all positions at a loss. Most people are smarter than that and try to get their feet wet in trading forex with a little bit more. A typical forex trader might start off with $200 in a micro account, but even that size is under-capitalized. Even if he were trading just 1 micro lot at time with a 100 pip stop loss, it only takes 10 bad trades (a scenario everyone must anticipate) for him to lose 50% of his account. And once he reaches that point, it becomes extremely hard to get back to breakeven. As we shall see, one should be capitalized to the extent that 10 bad trades in a row only loses a max 20% of the account, a draw down that is far more easier to recover from than that of 50%. 

Conclusion

Employing the best money management practices can keep you in the game longer but it cannot ensure your account against crippling losses. Even if you employed the best money management practices on earth, your deficits in the knowledge and experience and system edge will slowly drain your account.

Thus, if you have a sum of money in your savings account that you can afford to lose, do not risk it all on trading forex. Trade only a fraction of it, until you have built up the requisite knowledge, experience and system edge, that allows you to win in this difficult market. Then when you have the confidence in your experience and system you have money in reserve that you can throw in and starting earning serious cash.

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