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. There's no stopping the train.
But if traders like George Soros are paying serious attention to risk management, don't you think you should too?
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.
It's the "how much" equation that is responsible for your returns
The core of effective risk management is getting your position size correct.
You position size is the "how much" part of your trading plan, and it's how much you trade that determines your returns.
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 much more important than the entry. Amateurs ignore this crucial point in search of the "Holy Grail" entry.
But how to get the "how much" equation correct?
It begins with objectives
Getting the how much equation correct starts with being very clear about your objectives.
Saying "I want to make money" is far from good enough. It may even be detrimental, because it's not well enough defined. It's the same as a small business owner saying: "I would like to sell my product". Obviously that's the case – it's always the 'how' that matters.
Instead, the professional starts with their goal first. Say for instance they would like to have a 7% month. Then, they devise a trading plan and money management rules to achieve that goal.
There are several objectives that a professional will have in their plan. For the sake of simplicity let's start by getting these five down pat:
- Your return objective. How much do you want to make from trading each day, week, month or year? (Depending on your trading approach.)
- You drawdown objective. What is the maximum loss you are willing to sustain, in order to achieve your return objective over the same time period?
- The number of trading opportunities. How many trades do you plan to take over that time period? (Is it one a day; two a week?)
- Your targeting risk vs. reward on your trades. 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.
- Your targeted win rate. How many trades do you plan to get right compared to how many you get wrong or close at break-even? For example if you get half your trades correct you will have a win rate of 50%.
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 and realize you can adapt them as you gain experience.
Either way, you will find having these goals in place quite enlightening, as you can now manage your performance towards the achievement of the goals. This is a much more fulfilling way to trade than trading just for the sake of it.
Know when you are going to get out before you get in
Hand-in-hand with 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 directly with their broker as a stop-loss.
And don't fear being stopped out. Having losing trades is simply a cost of doing business.
Where to place the stop-loss?
This will take some testing and experience to get right. When you think about your system's stop-loss placements, consider the following:
- Put stops at points where, if they get hit, you know your idea has to have been wrong. If your trade is susceptible to market noise, you can get whipsawed out only to have been right overall. Perhaps you keep it behind a key level.
- Don't try and manufacture a trade with a good risk/reward ratio by tightening the stop-loss. Place it logically where the market dictates. If the risk/reward ratio for that trade is not good enough, then simply do not take it.
- Avoid putting stops directly on the high or low. Instead, keep it 10-25 pips beyond the level. There is nothing more frustrating than getting stopped out on the high or low of the day!
You should also have a clear plan for exiting if you are in profit. Again, this will require some testing, but it can be good to take a little bit of profit quickly, take some more at your target, and leave a portion to run for a big win.
Nuts and bolts: Calculating your position size
When 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.
To do this, we have put together a handy spreadsheet where you can input your objectives.Download the spreadsheet
Once you have worked out your risk percentage, you then calculate your trade size.
You do this by calculating the number of pips between your entry and your stop-loss, and then inputting it into a risk calculator along with the account balance, and risk percentage.
Here is a risk calculator that you can use for the purpose:
Baby pips risk calculator
This will tell you exactly how much currency to purchase on the trade. Using a calculator is important, as different currencies have different values. A $10,000 trade in GBPUSD is going to be different from a $10,000 trade in USDJPY for example. The calculator keeps it all nice and tidy.
That way you can get the "how much" equation exactly right, in order to achieve your goals.
Next you need to consider your leverage.
Controlling your leverage
Your leverage determines the amount of currency you can purchase in your trading account.
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. That should be based on your objectives.
Where leverage is important is in controlling the total amount of trades you have in your account at any one time. You want to have a maximum limit of leverage you are willing to accept on your account.
For example, you might have five trades totalling $50,000 with an account balance of $50,000 meaning you are leveraged 10:1.
Most pros will limit their leverage to 5-10:1. This is different from the leverage your broker allows you to have. It's a critical distinction to make.
Focus your energy
A smart trader has to be different from the majority.
Be like the pro, and spend your energy on solving the risk management problem. Once you have a suitable risk management framework in place, a lot of other decisions become a lot less arduous.
Start by getting very clear on your objectives.
Then practice calculating your position size by placing trades in your practice account.
After a while, it will all come naturally. And when it does, you will already be a better risk manager than 95% of Forex traders.