Step 3: Establish a Pain Threshold
Now that you’ve set your risk parameters on a per-trade basis and have a plan of attack for each trade, it’s time to establish a pain threshold.
What is a pain threshold, you ask?
(Don’t worry, it doesn’t require placing a rock on your head to find out)
I define it as the point at which you need an extended break from the market after a string of losses.
For example, let’s assume that you just lost four trades in a row. If you are risking 2% of your account balance on each trade, that amounts to an 8% loss of tradable equity.
(Technically it’s a bit less than 8% on a rolling basis, but we’ll keep things even for example purposes.)
I don’t care how good of a trader you are, that kind of back-to-back loss will rattle your nerves. It can cause you to doubt your abilities, which will inevitably lead to an even greater loss.
It’s a vicious cycle but one that you can avoid with the appropriate limits in place.
Now, let’s assume for a moment that your pain threshold is 10%. That means you can lose a total of 10% of your account balance from peak to trough before you must take a break.
In case you’re wondering, “peak to trough” is simply the change in value from the highest point to the lowest point. So if your account balance recently hit a high of $12,500, a 10% limit means that your threshold would trigger as soon as your account reaches $11,250.
Going back to our example, after four losing trades you’re still technically okay because you’ve lost a total of 8% from peak to trough.
But if you were to lose on the next trade without recouping any previous losses, your pain threshold would take effect and thus require you to take a break from the market.
Whether that break is a couple of days or a couple of weeks is up to you, as long as you return feeling refreshed and without any lingering thoughts of doubt.
Keep in mind that the smaller your risk per trade is that we defined in Step 1, the more wiggle room you’ll have unless of course you also decrease the pain threshold.
This level can vary from trader to trader.
However, in my experience, an acceptable range is somewhere between 5% and 10%. This allows you to account for a few consecutive losses, which are inevitable but also prevents you from losing so much that it becomes overly difficult to recover.
Final Words
Developing an effective Forex money management strategy with the proper risk control is a simple process when you know what needs to be defined.
Just like the price action strategies and patterns we trade, the best approach is a simple one. There’s no reason to overcomplicate this task, especially early on in your trading career.
It’s more important to have a plan that you understand and can follow on a daily basis. By keeping it simple and easy to understand, you’re more likely to adhere to the parameters you set.
After all, it isn’t the plan that will make you successful; it’s your ability to follow it.
Your Turn
What’s your strategy for managing money and controlling risk in the Forex market?
Leave your comment or question below and I’ll be sure to respond.