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
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.
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.
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
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.
You can find more how-to and educational articles to improve your investing and trading each day on TradingMarkets.com.
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
www.forexyourself.com, which is a forex introducing broker and education
company that helps suite client’s needs in forex trading. Alexander has a degree
with a concentration in Investment Banking and derivative instruments from Babson College in Massachusetts.