Risk (Money) Management Part 1 – Common Sense Tactics
StrWhen you decide to trade in the financial markets, the one thing you should never forget is that there is always the risk of losing some or all of your funds. But fortunately for traders, one of the few aspects of trading which we can control is the risks. We can´t move the market, we don´t have insight on the intentions of the central bank, we cannot predict the economic news or other fundamentals that create market movements – so we have to do our best to control the risk. There are many strategies and techniques to do so, which together are called “Risk Management” or “Money Management”.
Risk management means fitting all the small parts together
Many new traders enter this business with little risk or money management knowledge. That means that they are nearly gamblers, because they are reducing the tools they have at their disposition for trading, and consequently reducing the odds of winning. Risk management will not ensure a win every trade, but it will reduce the loss when you lose and will increase the profit when you win. It gives you that extra edge, which is all that is required to make you a winner in the long run. But what are these techniques that make trading safer? Some of them are just common sense techniques while others have been developed by statisticians and mathematicians and are a bit more complex. In this part of our two-part series, we will cover the common sense tactics. Let´s get started.
Exposure per trade – Probably the most important factor of risk management is to decide how much you are willing to actually risk per trade. Different traders risk different amounts of their accounts but professionals only risk a small percentage of the account, usually between 0.5% and 3%. The risk is calculated as a percentage of the total amount of the account. For example, if you have a $10,000 account and according to your analysis the stop loss must be 50 pips, then you shouldn´t trade more than 4 mini lots if you for a 2% exposure. 2% of a $10,000 account equals $200, so $4/pip x 50 pips = $200. That´s for the pairs where 1 pip costs $1 per mini lot: in other pairs like EUR/GBP, where 1 pip costs $1.5 per mini-lot, then you shouldn´t trade more than 2.5 mini lots according to the calculations.
Risk/reward ratio– Another important point of risk management is to define the risk/reward ratio. If you start a new business, it would be illogical to risk more than the reward potential of that business. The same idea goes for trading; when you pick a trade you´d want the potential profit to be bigger than the potential loss. The short-term trades usually have a higher risk/reward ratio, but when you are planning to open long-term positions, a good ratio is 1:3 to 1:5. This means that when the price is trading in the 100 pip range you won’t take sides in the middle of the ran , because the risk/reward ratio will be 1:1, or even worse, sell at the bottom and buy at the top. You wait for the price to reach the top of the range and sell the pair with a 30 pip stop loss above the resistance, targeting 70-80 pips just above the support/bottom of the range. As per the chart below, you´d have a much better risk/reward ratio if you sold the arrows and bought at the black marks instead of entering a trade somewhere in the middle.
Keep up-to-date with market conditions – You cannot make reasonable trading decisions if you don´t know what´s going on in the market. It´s the same as opening a new business in an industry where you don´t have any experience and aren’t sure how things work. Being unaware of the business environment is a wasted investment. In our case, we always have to know what´s going on in the forex market; we have to check the economic calendar and be up-to-date with all the economic and political news which might affect the main currencies we´re planning to trade. Fortunately, there are plenty of sites out there that offer the economic calendar and even offer explanation and analysis if you cannot interpret the news by yourself. On our site, we have daily market updates that offer prior explanations of what might happen during the day in relation to the upcoming events.
For more about using market movement to your advantage:
Leverage – All the brokers offer up to 400-500 times leverage, although since the Swiss Central Bank intervention in January, this might be reduced to 1:100. That seems very lucrative for traders because it means that you can make big profits with fewer funds. But high leverage can lead to big losses as well, which is why it is called a double-edged sword. If you use 100 times leverage on a $10,000 account and you lose 2 trades with a 40 pip stop loss on each, it means that you have lost $8,000 in just two trades. That´s nearly the entire account. If you want to last in this business you have to be very careful with the leverage. Most professionals don’t use more than 6-7 times leverage. Personally, since I don´t like to risk more than 2% of the account, I only use up to 5 times leverage.
Leverage is as useful as it is dangerous
Keeping a journal – Keeping a trading journal, is essentially like keeping a diary of your trades. Forex trading is very dynamic, which makes it difficult to see the mistakes you make in real time, thus increasing the risk of repeating them again and again. But if you look at the trading history at the end of the week/month you can easily identify your weak and strong points. There you can see which pairs have been the most profitable for you and avoid the losing ones. You can identify in which trading region (Asia, Europe, America) you have been most successful, and also see how successful you´ve been with trading during news releases, in order to realize if you have the capacity to read and interpret the news correctly. So, after identifying your weaknesses based on your trading journal, you will obviously avoid making the same mistakes, such as trading during certain times of the day or trading certain pairs. This will help you reduce the risk of trading under unfavorable conditions in the future.
For all the details about Keeping a Trading Journal – Forex Trading Strategies