Risk Management 101

Risk management is the most important trading principle an investor can employ. A very important aspect to the psychology of trading is the ability to create and maintain a trading plan. As a famous saying in the market goes, "if you fail to plan, plan to fail." Planning is closely linked to the discipline of a trader. Experienced traders know that discipline and a trading methodology are key to long term survival in the financial markets.

Common for very new traders to make money on demo accounts, but many times these same traders lose when entering the live market because they fail to exercise discipline when real money is involved. Trading Forex is a challenging and potentially profitable opportunity for educated and experienced investors. However, before deciding to participate in the market you should consider your investment objectives, level of experience and risk appetite. Most importantly, do not invest money you cannot afford to lose.

Money Management Strategy

Below is a Basic and effective money management strategy that will help you control your trading. Your risk per trade should never exceed 3% per trade. It's better to adjust your risk to 1% or 2%. I prefer a risk of 1% but if you are confident in your trading system then you can lever your risk up to 3%.

1% risk of a 10,000 account = 100.

You should adjust your stop loss so that you never lose more than 100 per a single trade. If you place your stop loss 50 pips below/above your entry point.

50 pip = 100 1 pip = 2

The size of your trade should be adjusted so that you risk $2/pip. If the trade is stopped, you will lose 100 which is 1% of your balance. Another key component to money management is Risk-to-Reward Ratios.

Risk-to-Reward Ratio

The following shows you possible risk-to reward ratios, and the win ratios required to break even in a trading system. Risk-to-Reward Ratio (in pips) and Win Ratio Required to Break Even (%)

40/20 (2 to 1) = 67%, 40/40 (1 to 1) = 50%, 40/60 (1 to 1.5) = 40%, 40/80 (1 to 2) = 33.5%, 60/20 (3 to 1) = 75%, 60/60 (1 to 1) = 50%, 60 /90 (1 to 1.5) = 40%, 60/120 (1 to 2) = 33.5%

Never risk more pips on a trade then you plan to make. It doesn't make sense to risk 100 pips in order to make only 10. Why? See below example.

Profit taking level (pips): 10

Stop used or pips at risk: 100

You win 10 times which makes 100 winning pips. You only lose once and have to give back all profits. Clearly a profit taking level of 10 and a risk level of 100 is not the best trading strategy. A more sensible strategy is 3 to 1. For example if you risk 10 pips you should be looking to make at least 30 pips in profit. Most traders analyze place sensible trades yet they tend to over leverage themselves, get in with a position that is too big for their portfolio, and as a consequence, often end up forced to exit a position at the wrong time. Trading in small increments with protective stops on your positions will allow one the opportunity to be successful in Forex trading.

Trading Discipline

Discipline is probably one of the most overused words in Forex trading education. Despite the cliché, discipline continues to be the most important behavior one can master to become a profitable trader. Discipline is the ability to plan your work and work your plan. It's the ability to give your trade the time to develop, without hastily taking yourself out of the market simply because you are uncomfortable with risk. Discipline is also the ability to continue to trade the methods and patterns even after you've suffered losses.

Many traders come with false expectations of the profit potential, and lack the discipline required for trading. Short term trading is not an amateur's game and is not the way most people will achieve quick riches. Forex trading may seem exotic or less familiar then traditional markets such as equities. However, it does not mean that the rules of finance and simple logic are suspended. One cannot hope to make extraordinary gains without extraordinary risks, and that means suffering inconsistent trading performance that often leads to large losses.

Trading currencies is not easy, and many traders with years of experience still incur losses on a periodic basis. One must realize that trading takes time to master and there are absolutely no short cuts to this process. One of the worst blunders that Forex traders can make is attempting to trade without sufficient capital. The trader with limited capital not only will be a worried trader, always looking to minimize losses beyond the point of realistic trading. He will also frequently be taken out of the trading game before he can realize any sense of success trading methods or patterns.

Protecting Capital and Minimizing Cost

The final aspect of risk management and trading discipline is protecting your capital. Forex traders who understand the importance of risk management and trading discipline usually understand the importance of protecting and preserving their capital. In the Forex market the easiest way for a trader to lose capital is through paying the spread. Some dealing firms charge extremely high spreads that can eat at a trader's capital without them noticing.

The solution to this problem is to find a broker that charges reasonable spreads and also search for trade rebate programs. Rebates are a fairly new concept in the Forex market, usually offered by Introducing brokers, a trade rebate is a way for a trader to be rebated on a small portion of the spread. Although a normal rebate is only a few dollars per standard lot, active traders soon realize how taking advantage of rebate is not only a smart thing, but also can greatly improve their profitability and overall trading success. Simply put, the less you pay in spread the greater your chances are of seeing profitable trade returns and trading longevity. Competitive spreads, not over-leveraging and a disciplined money management strategy are the keys to being successful in the Forex market.

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Alexander Nekritin is a professional trader with over 8 years of experience. His specialties include risk management and system development. Alexander is the CEO of NCMFX, Inc., which is a forex introducing broker and an educational company that helps suit client?s needs in forex trading. He offers a Forex Broker Review to his clients that assists in learning the MetaTrader4 platform. Alexander has a degree with a concentration in Investment Banking and derivative instruments from Babson College in Massachusetts.