Risk management is a phrase traders love to hate. It’s the first thing new forex traders are taught, and it’s the first thing they ignore.
No matter how much the pros emphasise risk management, the new trader is too easily distracted by the lure of their charts.
The good news is that risk management is a solvable problem. It’s just a matter of applying some simple maths to your trading. Let’s start by making sure you know why risk management is so important.
The core of effective risk management is getting your position size correct. Your position size is the “how much” part of your trading plan. How much you trade is what determines your returns and risk.
Think about it. You can have the exact same entry and exit but make completely different amounts depending on the size you trade. Your position size is what determines if you make 0.1%, 1%, 10%, or any other amount from the very same trade.
Pros know that controlling the size of the position is more important than the entry. Amateurs ignore this crucial point in search of the “Holy Grail” entry.
So, how do you get the “how much” equation correct?
Getting the “how much” equation correct starts with being very clear about your objectives.
A professional will start with a specific trading goal. For example, say they would like to have a 7% month. They devise a trading plan and come up with the money management rules that help them achieve that goal.
There are several objectives that a professional will have in their plan. For the sake of simplicity, let’s start with these five simple objectives:
How much do you want to make from trading each day, week, month or year? The answer should depend on your trading approach.
What is the maximum loss you are willing to sustain to achieve your return objective over the same period?
How many trades do you plan to take over that period? Be as specific as possible.
What will your average profit on a trade be, as compared to the risk you are willing to take? For example, if you are willing to risk 50 pips on a trade, and are looking to make 100 pips, then your risk/reward would be 1:2.
How many trades do you plan to get right compared to how many you get wrong or close at break-even?
If you have a good understanding of your trading system, you may find these objectives relatively simple. If not, don’t sweat it. Spend some time thinking about what you would like to work towards.
As well as having well-defined objectives, the professional knows exactly when they are going to get out of a trade before they get in. Pros always have a pre-planned exit point if their position goes against them. For most traders, this should be set as a stop-loss.
Don’t fear being stopped out. Having losing trades is simply a cost of trading.
This will take some testing and experience to get right. When you think about your system’s stop-loss placements, consider the following:
You should also have a clear plan for exiting if you are in profit. Again, this will require some testing. It can be good to take a little profit quickly, take some more at your target, and leave a portion to run for a big win.
Once you have your objectives and a predefined exit point, you can calculate your position size. First, you need to calculate the percentage of your account you are going to risk on the trade. Once you’ve worked out your risk percentage, you then calculate your trade size.
You do this by:
Here is a risk calculator that you can use for the purpose:
This calculator will tell you exactly how much currency to purchase on the trade. Using a calculator is important, as different currencies have different values. For example, a $10,000 trade in GBP/USD is going to be different from a $10,000 trade in USD/JPY. The calculator keeps it all nice and tidy.
That way you can get the “how much” equation exactly right to achieve your goals. Next, you need to consider your leverage.
Your leverage determines the amount of currency you can trade. For example, if you have 100:1 leverage you can purchase $100,000 of currency for each $1,000 you have in your account. The first point to understand is that the amount of leverage you have on your account should not determine your position size. It should be based on your objectives.
Start by getting very clear on your objectives. Then, practice calculating your position size by placing trades in your demo account. After a while, it will all come naturally. When it does, you will already be a better risk manager than 99% of traders.