Risk Management For Forex Traders
Risk management is probably the most important factor when trading.
Firstly, you must understand what your goal is.
Your goal as a trader is to preserve your capital whilst growing it.
This can only be achieved by applying strict risk management, such as knowing when to cut your losses or when to reduce your trading sizes whilst you are underperforming.
In fact, if you don’t use risk management then you might as well be a retail gambler – even professional gamblers use risk management!!
The simplest concept of trading and risk management is this simple sentence; you may have heard of it before:
Cut your losses short and let your winners run!
Simple right? If only.
Taking profit or letting your winners run is easy on a psychological level.
Cutting or taking a loss is where it is difficult; no one wants to lose at anything, let alone their own money.
However, remember this – traders who let their losses run and take their profits early will increase their losers over time.
Conversely, traders that let their losses get stopped out early and let their profits run will perform better over time.
Trading is not about your winning percentage, you’re big wins or anything that can inflate your ego.
Trading is all about how much money you can consistently pull in profits. That is the only figure that matters.
Some of the best investors have a low winning percentage.
Let’s give you an example; which investor would you prefer?
Investor A – Traded 100 times over 12 months. 78 trades were winners. Made $5,000 in profits.
Investor B – Traded 50 times over 12 months. 10 trades were winners. Made $15,000
Investor A had a much higher winning percentage but took profits often and too little.
Investor B had a much lower winning percentage, but let profits run and cut losses early.
Investor B shows a clear understanding of risk management whilst in active trade and has been rewarded handsomely for his approach.
In this arena, we do not care what the price of the asset is, just the opportunity to make money from it.
Buy something because it looks cheap is a fool’s way to lose their money.
Equally, shorting an asset because it looks like a top is an even easier way to lose your money.
Price to us is an indicator of movement and momentum. That is it.
The only thing that relates to the price for us is the amount we wish to risk.
If you have no clue about how much you wish to invest in a position or your exit points, you would fare better on a roulette table.
In this business, we are in the game of risk.
To risk X% in seek of a greater return.
Types of Risk Management
There are three significant levels of risk management which must be practised and managed with each trade you implement. These are:
Why do we use Risk Management?
We use risk management to ensure that we have an execution plan that allows us to control the entry, the position size, the amount to the risk and when to exit a position based on a certain criterion.
The criteria are something that you come up with to give your trades the best possible chance of profiting.
Without risk management, you will end up gambling.
Without risk management, there is no way to fundamentally organise your trades to better yourself as performance increases nor is there a way to prevent heavier than necessary losses to occur when you are underperforming.
Don’t forget, you only make or lose money WHEN you have executed the trade, so this is why risk management is important to get right.
You should consider this as a step-by-step action plan on how to enter and exit trades.
The reason why it is a plan is that it allows us to adjust to different environments quickly and find out what part of the plan is not working well for you.
Plus you can easily change and modify any part of your plan you see fit.
Don’t want to risk more than 4% per trade? Change it.
How to use risk management
Risk management can be as simple as you’d like it, or as sophisticated as you’d like.
At the most basics, you can simply work out how much you want to trade at the lowest level and set the stop loss to 10% of the margin.
For example, You have £10,000 invested. You only want to risk 2% of the capital per trade.
This means you have £200 to put into a trade.
With £200 as your position size, you can set the stop loss so you only risk £20. £20 is 10% of £200.
As you are risk £20, you wish to make at least £20 profit and set a take profit order to close the trade when you are in a profit of £20.
If the market moves against you, your stop loss would be hit, and you’d lose £20.
If the market moves in your favour, your take profit order would be hit, and you’d profit £20.
This is risk management at its most basic form.
Or you can take on a more sophisticated approach:
Based on your performance you could put it through a calculation which would increase or decrease your trading position size based on your previous trade.
If you were profitable – the trade position size would increase – meaning you would risk more capital. However, as you are performing right now, it’s time to take advantage of your excellence.
If you were not-profitable – the trade position size would decrease – meaning you would less capital. This is to reduce any potential further losses whilst you are underperforming.
In addition, a formula would be used to generate the appropriate performance-adjusted risk – so you may go from risking 10% of the trade position to 14% and vice versa.
This technique adds one extra layer to risk management which is really beneficial to traders.
This type of risk management is used by hedge funds.
We will guide you through this method later on.