Risk management is one of the most important topics you will ever read about trading.
Why is it important? Well, we are in the business of making money, and in order to make money we have to learn how to manage risk (potential losses).
Ironically, this is one of the most overlooked areas in trading. Many forex traders are just anxious to get right into trading with no regard for their total account size.
They simply determine how much they can stomach to lose in a single trade and hit the “trade” button. There’s a term for this type of investing….it’s called…
GAMBLING!
When you trade without risk management rules, you are in fact gambling.
You are not looking at the long term return on your investment. Instead, you are only looking for that “jackpot.”
Risk management rules will not only protect you, but they can make you very profitable in the long run. If you don’t believe us, and you think that “gambling” is the way to get rich, then consider this example:
People go to Las Vegas all the time to gamble their money in hopes of winning a big jackpot, and in fact, many people do win.
So how in the world are casinos still making money if many individuals are winning jackpots?
The answer is that while even though people win jackpots, in the long run, casinos are still profitable because they rake in more money from the people that don’t win. That is where the term “the house always wins” comes from.
The truth is that casinos are just very rich statisticians. They know that in the long run, they will be the ones making the money–not the gamblers.
Even if Joe Schmoe wins a $100,000 jackpot in a slot machine, the casinos know that there will be hundreds of other gamblers who WON’T win that jackpot and the money will go right back in their pockets.
This is a classic example of how statisticians make money over gamblers. Even though both lose money, the statistician, or casino in this case, knows how to control its losses. Essentially, this is how risk management works. If you learn how to control your losses, you will have a chance at being profitable.
In the end, forex trading is a numbers game, meaning you have to tilt every little factor in your favor as much as you can. In casinos, the house edge is sometimes only 5% above that of the player. But that 5% is the difference between being a winner and being a loser.
You want to be the rich statistician and NOT the gambler because, in the long run, you want to “always be the winner.”
So how do you become this rich statistician instead of a loser? Keep reading!
Lets see how much trading cap you need to trade forex?
It takes money to make money. You need trading capital. Everyone knows that, but how much does one need to get started in forex trading? The answer largely depends on how you are going to approach your new start-up business.
First, consider how you are going to be educated. There are many different approaches in learning how to trade: classes, mentors, on your own, or any combination of the three.
While there are many classes and mentors out there willing to teach forex trading, most will charge a fee. The benefit of this route is that a well-taught class or great mentor can significantly shorten your learning curve and get you on your way to profitability in a much shorter amount of time compared to doing everything yourself.
The downside is the upfront cost for these programs, which can range from a few hundred to a few thousand dollars, depending on which program you go with. For many of those new to trading, the resources (money) required to purchase these programs are not available.
As long as you are disciplined and laser-focused on learning the markets, your chances of success increase exponentially. You have to be a gung ho student. If not, you’ll end up in the poor house.
Second, is your approach to the markets going to require special tools such as news feeds or charting software? As a technical forex trader, most of the charting packages that come with your broker’s trading platform are sufficient (and some are actually quite good).
For those who need special indicators or better functionality, higher-end charting software can start at around $100 per month.
Maybe you’re a fundamental trader and you need the news the millisecond it is released, or even before it happens (wouldn’t that be nice!).
Well, instantaneous and accurate news feeds run from a few hundred to a few thousand dollars per month. Again, you can get a complimentary news feed from your forex broker, but for some, that extra second or two can be the difference between a profitable or unprofitable trade.
Finally, you need money/capital/funds to trade. Retail forex brokers offer minimum account deposits as low as $25, but that doesn’t mean you should enter immediately! This is a capitalization mistake, which often leads to failure. Losses are part of the game, and you need to have enough capital to weather these losses.
So how much trading capital do you need? Let’s be honest here, if you’re consistent and you practice proper risk management techniques, then you can probably start off with $50k to $100k in trading capital.
It’s common knowledge that most businesses fail due to undercapitalization, which is especially true in the forex trading business.
So if you are unable to start with a large amount of trading capital that you can afford to lose, be patient, save up and learn to trade the right way until you are financially ready.
Never Risk More Than 1% or 2% Per Trade
How much should you risk per trade?
Great question. Try to limit your risk to 2% per trade.
But that might even be a little high. Especially if you’re newbie forex trader.
Here is an important illustration that will show you the difference between risking a small percentage of your capital per trade compared to risking a higher percentage.
Trader Risks 2% vs. 10% Per Trade
| Trade # | Total Account | 2% risk on each trade | Trade # | Total Account | 10% risk on each trade |
|---|---|---|---|---|---|
| 1 | $20,000 | $400 | 1 | $20,000 | $2,000 |
| 2 | $19,600 | $392 | 2 | $18,000 | $1,800 |
| 3 | $19,208 | $384 | 3 | $16,200 | $1,620 |
| 4 | $18,824 | $376 | 4 | $14,580 | $1,458 |
| 5 | $18,447 | $369 | 5 | $13,122 | $1,312 |
| 6 | $18,078 | $362 | 6 | $11,810 | $1,181 |
| 7 | $17,717 | $354 | 7 | $10,629 | $1,063 |
| 8 | $17,363 | $347 | 8 | $9,566 | $957 |
| 9 | $17,015 | $340 | 9 | $8,609 | $861 |
| 10 | $16,675 | $333 | 10 | $7,748 | $775 |
| 11 | $16,341 | $327 | 11 | $6,974 | $697 |
| 12 | $16,015 | $320 | 12 | $6,276 | $628 |
| 13 | $15,694 | $314 | 13 | $5,649 | $565 |
| 14 | $15,380 | $308 | 14 | $5,084 | $508 |
| 15 | $15,073 | $301 | 15 | $4,575 | $458 |
| 16 | $14,771 | $295 | 16 | $4,118 | $412 |
| 17 | $14,476 | $290 | 17 | $3,706 | $371 |
| 18 | $14,186 | $284 | 18 | $3,335 | $334 |
| 19 | $13,903 | $278 | 19 | $3,002 | $300 |
You can see that there is a big difference between risking 2% of your account compared to risking 10% of your account on a single trade!
If you happened to go through a losing streak and lost only 19 trades in a row, you would’ve went from starting with $20,000 to having only $3,002 left if you risked 10% on each trade.
You would’ve lost over 85% of your account!
If you risked only 2% you would’ve still had $13,903 which is only a 30% loss of your total account.
Of course, the last thing we want to do is to lose 19 trades in a row, but even if you only lost 5 trades in a row, look at the difference between risking 2% and 10%. If you risked 2% you would still have $18,447. If you risked 10% you would only have $13,122. That’s less than what you would’ve had even if you lost all 19 trades and risked only 2% of your account!
The point of this illustration is that you want to setup your risk management rules so that when you do have a drawdown period, you will still have enough capital to stay in the game.
Can you imagine if you lost 85% of your account?!!
You would have to make 566% on what you are left with in order to get back to break even!
Trust us, you do NOT want to be in that position. You’d start looking a lot like Cyclopip. Do you wanna look like Cyclopip? Didn’t think so!
Here is a chart that will illustrate what percentage you would have to make to breakeven if you were to lose a certain percentage of your account.
| Loss of Capital | % Required to get back to breakeven |
|---|---|
| 10% | 11% |
| 20% | 25% |
| 30% | 43% |
| 40% | 67% |
| 50% | 100% |
| 60% | 150% |
| 70% | 233% |
| 80% | 400% |
| 90% | 900% |
You can see that the more you lose, the harder it is to make it back to your original account size. This is all the more reason that you should do everything you can to PROTECT your account.
By now, we hope you have gotten it drilled in your head that you should only risk a small percentage of your account per trade so that you can survive your losing streaks and also to avoid a large drawdown in your account.
Remember, you want to be the casino… NOT the gambler!
Reward-to-Risk Ratio
Another way you can increase your chances of profitability is to trade when you have the potential to make 3 times more than you are risking. If you give yourself a 3:1 reward-to-risk ratio, you have a significantly greater chance of ending up profitable in the long run.
Take a look at this chart as an example:
| 10 Trades | Loss | Win |
|---|---|---|
| 1 | $1,000 | |
| 2 | $3,000 | |
| 3 | $1,000 | |
| 4 | $3,000 | |
| 5 | $1,000 | |
| 6 | $3,000 | |
| 7 | $1,000 | |
| 8 | $3,000 | |
| 9 | $1,000 | |
| 10 | $3,000 | |
| Total | $5,000 | $15,000 |
In this example, you can see that even if you only won 50% of your trades, you would still make a profit of $10,000. Just remember that whenever you trade with a good risk to reward ratio, your chances of being profitable are much greater even if you have a lower win percentage.
BUT…
And this is a big one, like Jennifer Lopez’s behind… setting large reward-to-risk ratio comes at a price. On the very surface, the concept of putting a high reward-to-risk ratio sounds good, but think about how it applies in actual trade scenarios.
Let’s say you are a scalper and you only wish to risk 3 pips. Using a 3:1 reward to risk ratio, this means you need to get 9 pips. Right off the bat, the odds are against you because you have to pay the spread.
If your broker offered a 2 pip spread on EUR/USD, you’ll have to gain 11 pips instead, forcing you to take a difficult 4:1 reward to risk ratio. Considering the exchange rate of EUR/USD could move 3 pips up and down within a few seconds, you would be stopped out faster than you can say “Uncle!”
If you were to reduce your position size, then you could widen your stop to maintain your desired reward/risk ratio. Now, if you increased the pips you wanted to risk to 50, you would need to gain 153 pips. By doing this, you are able to bring your reward-to-risk ratio somewhere nearer to your desired 3:1. Not so bad anymore, right?
In the real world, reward-to-risk ratios aren’t set in stone. They must be adjusted depending on the time frame, trading environment, and your entry/exit points. A position trade could have a reward-to-risk ratio as high as 10:1 while a scalper could go for as little as 0.7:1.
Position Sizing
Now that we’ve learned the hard lesson of trading too big, let’s get into how to correctly use leverage using proper “position sizing.”
Position sizing is setting the correct amount of units to buy or sell of currency pair.
It is one of the most crucial skills in a forex trader’s skill set.
Actually, we’ll go ahead and say it is THE most important skill.
Traders are “risk managers” first and foremost, so before you start trading real money you should be able to do basic position size calculations in your sleep… or at least after you wake up, still groggy, and try to trade the NFP report!
Depending on the currency pair you are trading and your account denomination (is your account in dollars, euros, pounds, etc??), a step or two needs to be added to the calculation.
Now, before we can get our math on, we need five pieces of information:
- Account equity or balance
- Currency pair you are trading
- The percent of your account you wish to risk
- Stop loss in pips
- Conversion currency pair exchange rates
Easy enough right? Let’s move on to a few examples.
Calculating Position Sizes
To make things easier for you to understand, as usual, we’ll be explaining everything with an example.
This is Newbie Ned.
Long time ago, back when he was even more of a newbie than he is now, he blew out his account because he put on some enormous positions.
It was as if he was a gun slinging cowboy from the Midwest – he traded from the hip and traded BIG.
Ned didn’t fully understand the importance of position sizing and his account paid dearly for it.
He re-enrolled into the Pips Akademy to make sure that he understands it fully this time, and to make sure what happened to him never happens to you!
In the following examples, we’ll show you how to calculate your position size based on your account size and risk comfort level.
Your position size will also depend on whether or not your account denomination is the same as the base or quote currency.
Account Denomination the same as the Counter Currency
Newbie Ned just deposited USD 5,000 into his trading account and he is ready to start trading again. Let’s say he now uses a swing trading system that trades EUR/USD and that he risks about 200 pips per trade.
Ever since he blew out his first account, he has now sworn that he doesn’t want to risk more than 1% of his account per trade. Let’s figure how big his position size needs to be to stay within his risk comfort zone.
Using his account balance and the percentage amount he wants to risk, we can calculate the dollar amount risked.
USD 5,000 x 1% (or 0.01) = USD 50
Next we divide the amount risked by the stop to find the value per pip.
(USD 50)/(200 pips) = USD 0.25/pip
Lastly, we multiply the value per pip by a known unit/pip value ratio of EUR/USD. In this case, with 10k units (or one mini lot), each pip move is worth USD 1.
USD 0.25 per pip * [(10k units of EUR/USD)/(USD 1 per pip)] = 2,500 units of EUR/USD
So, Newbie Ned should put on 2,500 units of EUR/USD or less to stay within his risk comfort level with his current trade setup.
Pretty simple eh? But what if your account is the same as the base currency?
Account Denomination the same as Base Currency
Let’s say Ned is now chilling in the euro zone, decides to trade forex with a local broker, and deposits EUR 5,000.
Using the same trade example as before (trading EUR/USD with a 200 pip stop) what would his position size be if he only risked 1% of his account?
EUR 5,000 * 1% (or 0.01) = EUR 50
Now we have to convert this to USD because the value of a currency pair is calculated by the counter currency. Let’s say the current exchange rate for 1 EUR is $1.5000 (EUR/USD = 1.5000).
All we have to do to find the value in USD is invert the current exchange rate for EUR/USD and multiply by the amount of euros we wish to risk.
(USD 1.5000/EUR 1.0000) * EUR 50 = approx. USD 75.00
Next, divide your risk in USD by your stop loss in pips:
(USD 75.00)/(200 pips) = $0.375 a pip move.
This gives Ned the “value per pip” move with a 200 pip stop to stay within his risk comfort level.
Finally, multiply the value per pip move by the known unit-to-pip value ratio:
(USD 0.375 per pip) * [(10k units of EUR/USD)/(USD1 per pip)] = 3,750 units of EUR/USD
So, to risk EUR 50 or less on a 200 pip stop on EUR/USD, Ned’s position size can be no bigger than 3,750 units.
Still pretty simple, eh?
To learn how to calculate position sizes, there are position size calculator available at forex-calculators when it opens up, choose position size calculator or any of the calculator you need.
Why my stop loss keep getting hit
Let’s face it. The market will always do what it wants to do, and move the way it wants to move. Every day is a new challenge, and almost anything from global politics, major economic events, to central bank rumors can turn currency prices one way or another faster than you can snap your fingers.
This means that each and every one of us will eventually take a position on the wrong side of a market move.
Being in a losing position is inevitable, but we can control what we do when we’re caught in that situation. You can either cut your loss quickly or you can ride it in hopes of the market moving back in your favor.
Of course, that one time it doesn’t turn your way could blow out your account and end your budding trading career in a flash.
The saying, “Live to trade another day!” should be the motto of every trader on Newbie Island because the longer you can survive, the more you can learn, gain experience, and increase your chances of success.
This makes the trade management technique of “stop losses” a crucial skill and tool in a trader’s toolbox.
Having a predetermined point of exiting a losing trade not only provides the benefit of cutting losses so that you may move on to new opportunities, but it also eliminates the anxiety caused by being in a losing trade without a plan.
Less stress is good, right? Of course it is, so let’s move on to different ways to cut ’em losses quick!
Now before we get into stop loss techniques, we have to go through the first rule of setting stops.
Your stop loss point should be the “invalidation point” of your trading idea.
When price hits this point, it should signal to you “It’s time to get out buddy!”
4 Big Mistakes Traders Make When Setting Stops
In this section, we’ll talk about the common mistakes traders make when using stops. Sure, it’s one way to practice proper risk management but when used incorrectly, it could lead to more losses than wins. And you don’t want that, do ya?
1. Placing stops too dang tight.
In placing ultra-tight stops on trades, there won’t be enough “breathing room” for the price to fluctuate before ultimately heading your way.
Always remember to account for the pair’s volatility and the fact that it could dilly-dally around your entry point for a bit before continuing in a particular direction.
For instance, let’s say you went long GBP/JPY at 145.00 with a stop at 144.90. Even if you are right in predicting that the price would bounce from that area, it’s a possibility that the price will still dip 10-15 pips lower than your entry price before popping higher, probably until 147.00.
But guess what?
You weren’t able to rake in a 200-pip profit because you got stopped out in a jiffy. So don’t forget: Give your trade enough breathing room and take volatility into account!
2. Using position size like “X number of pips” as a basis for stops.
We’ve mentioned this earlier in the lesson already: Using position size like “X number of pips” or “$X amount” instead of technical analysis to determine stops is a BAD idea. We learned that from Newbie Ned, remember?
As we discussed, using position sizing to calculate how far your stop should be has nothing to do with how the market is behaving. Since we’re trading the market, it’d make much more sense to set stops depending on how the market moves.
After all, you picked your entry point and targets based on technical analysis so you should do the same for your stop. 
We’re not saying that you should forget about position size completely. What we’re recommending is that you should decide where to place your stops first BEFORE calculating your position size.
3. Placing stops too far or too wide.
Some traders make the mistake of setting stops way too far, crossing their fingers that price action will head their way sooner or later. Well, what’s the point of setting stops then?
What’s the point of holding on to a trade that keeps losing and losing when you can use that money to go for a more profitable one?
Setting stops too far increase the amount of pips your trade needs to move in your favor to make the trade worth the risk.
The general rule of thumb is to place stops closer to entry than profit targets.
Of course you’d want to go for less risk and bigger reward, right? With a good reward-to-risk ratio, say 2:1, you’d be more likely to end up with profits if you’re right on the money with your trades at least 50% of the time.
4. Placing stops exactly on support/resistance levels.
Setting stops too tight? Bad. Setting stops too far? Bad. Where exactly is a good stop placed then? Well, not exactly on support or resistance levels, we can tell you that. How come?
Didn’t we just say that technical analysis is the way to go when determining stops? Sure, it’s helpful to note nearby support and resistance levels when deciding where to place stops.
If you’re going long, you can just look for a nearby support level below your entry and set your stop in that area. If you’re going short, you can find out where the next resistance level above your entry is and put your stop around there.
But why isn’t it a good idea to put it right smack on the support or resistance level? The reason is that the price could still have a chance to turn and head your direction upon reaching that level.
If you place your stop a few pips beyond that area then you’d be more or less sure that the support or resistance is already broken and you can then acknowledge that your trade idea was wrong.
3 Rules To Follow When Using Stop Loss Orders
Once you’ve done your homework and created an awesome trade plan that includes a stop out level, you now have to make sure that you execute those stops if the market goes against you.
There’s two ways to do that. One is by using an automatic stop and another through a mental stop.
Which one is best suited for you?
Here’s where the hard part comes in as the answer to this question lies in your level of discipline.
Do you have the mental toughness and self-control to stick to your stops?
In the heat of battle, what often separates the long-term winners from the losers is whether or not they can objectively follow their predetermined plans.
Traders, especially the more inexperienced ones, often question themselves and lose that objectivity when the pain of losing kicks in and brings in negative thoughts like, “Maybe the market will turn right here. I should hold a bit longer and then it will go my way.”
Wrong!
If the market has reached your stop, your reason for the trade is no longer valid and it’s time to close it out… No questions asked!
This is why the almighty forex gods invented limit orders. New forex traders should always use limit orders to automatically close out a losing trade at predetermined levels.
This way you won’t give yourself the chance to doubt your plan and make a mistake. You won’t even have to be sitting in front of your trading station to execute the order.
How awesome is that?!
Of course, the more trades and experience you have under your belt, the more you will hopefully have a better understanding of market behavior, your methods, and the more disciplined you will be.
Only then would mental stops be okay to use, but we still HIGHLY recommend limit orders to exit the majority of your trades.
Manually closing trades leaves yourself open to making mistakes (especially during unforeseen events) such as entering the wrong price levels or position size, a power outage, a coffee binge induced bathroom marathon, etc.
Don’t leave your trade open to unnecessary risk so always have a limit order to back you up!
Because stops are never set in stone and you have the ability to move them, we will end this lesson with 3 rules to follow when using stop loss orders.
- Don’t let emotions be the reason you move your stop. Like your initial stop loss, your stop adjustments should be predetermined before you put your trade on. Don’t let panic get in the way!
- Do trail your stop. Trailing you stop means moving it in the direction of a winning trade. This locks in profits and manages your risk if you add more units to your open position.
- Don’t widen your stop. Increasing your stop only increases your risk and the amount you will lose. If the market hits your planned stop then your trade is done. Take the hit and move on to the next opportunity. Widening your stop is basically like not having a stop at all and it doesn’t make any sense so to do it! Never widen your stop!
These rules are pretty easy to understand and should be followed religiously, especially rule number 3!
Want us to repeat it again?
DO NOT WIDEN YOUR STOP!
Always remember to plan your trade ahead and figure out what to do in each scenario so that you won’t panic and do something you’d probably regret later on.
No comments:
Post a Comment