Thorough and stringent guidelines for trading risk management are necessary, without which even the best trading strategy can fail. In fact, if a professional trader is asked to trade without managing his risks, there are high chances that he would incur a substantial loss.
Trade risk management is an essential part of trading. One needs to protect their trading capital before trying to seek profit. In order to do this, traders use stop-losses on every individual trade. The different stop losses that one can use are:
Equity Stop – A stop-loss on a specific percentage of the trading capital
Chart Stop – Stop-losses on some major price levels on a particular chart
Volatility Stop – A stop-loss on the average volatility level of a currency pair
There are several other stop losses that one can use too. Since the chart stops are based directly on market performance, they generally provide the best results in the long run. On the other hand, using equity stops is essential for protecting trading capital. By using a combination of equity stops and chart stops, you will be able to better manage your risk and set yourself up for success.
Further, one can manage trade risk effectively by using two crucial ratios – the risk-per-trade ratio that refers to the maximum bearable loss and the risk-to-reward ratio that refers to the ratio between the possible profit and loss of a specific trade setup.
A common myth among retail traders is that a strategy that works at all times is a good strategy.
The reason for this being untrue is that being correct at majority times and the average profit earned are negatively related. A trading strategy that is likely to work at all times will generate smaller profits. However, these strategies tend to result in big losses when they fail. Retail traders generally face this issue where the profits earned by several months of trading get wiped out by a few big losses.
Alternatively, trade strategies that emphasize on returning small losses and large gains are less likely to be right at all times as they shut down non-performing trades quickly. However, they also keep strong winning positions open for longer. This results in a winning rate of around 40%, where the winning trades are about two to three times the average loss trades.
While being right of most of the time has its own advantages, a few losses in a row can eat up your trading capital. On the contrary, a trading strategy with only a 40% profitability rate would mean that 60% of your trades would prove to be losses, which is not favored by many.
Since both such trading strategies have negative aspects to them, most professional traders strive to find a middle ground and stick to it.
Determining the Risk for Each Trade
Knowing the amount of risk, you are willing to take on a single trade is an essential part of the complete trading plan. A primary reason why many beginners incur losses rapidly at the start is that they fail to establish this.
Novice traders tend to employ random risk-per-trade levels – generally resulting in overleveraging of trades and risking the entire account on just a few trades. Usually, the trading account is used as the basis for measuring risk-per-trade, and it constitutes only a small percentage of the account. As the golden rule of trade risk management goes, one should risk a maximum of 1-2% of their trading account. For instance, for a trading account of $10,000, the risk per trade should not exceed $100 or $200, with the former being 1% of the capital and the latter 2% of the capital.
This is crucial to ensure that a string of loses does not wipe out a big amount of your trading account. When you incur a loss, you need to make substantial amounts of profits to re-attain the initial account balance. The table below will help you understand this further:
Percentage of Loss
Required Profit Percentage to Re-attain Initial Balance
To minimize the potential loss during a sequence of bad trades, you should risk around 1-2% only on each trade. Professional traders that manage other people’s money tend to risk even less at about 0.5% of their capital per trade. Also, high-frequency traders tend to split up their risk across all of their positions of the day, so if they have a bad day, they will only end up losing 1 to 2 percent of their capital. This short-term trader would not risk 1% per trade, because if they trade ten times per day and lose all times, then they would deplete half of their account by the time the week is up.
Always remember that the primary motive while trading is to preserve the capital, and if the downside can be maintained, then the gains will come. But if you lose all of your money in a few trades, it will be almost impossible to claw back your losses as seen in the table above. A trader that risks 10% of their capital would after five bad trades need to produce a 100% return to return to their initial balance. As a comparison, the average return of the S&P 500 index is about 9.7% per year, while the average return of Warren Buffets Berkshire Hathaway over the last few decades is about 19.1%. A 100% return is, therefore almost impossible without taking excessive risks. Also, losing five trades in a row is very simple. If risking just 1% of the capital per trade, the traders would be down by 5%, which is easier to recuperate, than a 50% drop in equity.
As you get more trading experience, it will become easy to single out trading opportunities where you can risk a larger amount. But before earning such experience, it is in your best interest that you keep your risks to the minimum.
After you have decided the maximum risk-per-trade you are willing to take, you will have to lock it in by employing stop-losses. Stop-loss orders shut down trades automatically when the price moves against you and reached a predefined level.
For example, let us consider a buy position on the EUR/USD pair that is currently trading at 1.2000. If you place an order to stop a loss at 1.1900, the trade will be automatically shut down by your broker when the price reaches the 1.1900 mark.
The actual stop will in most instances be determined by using technical analysis, and in the case of a buy position, a stop tends to be below an important support level, while in a downtrend the stop level tends to be just above a resistance level.
Steps to Determine the Position Size
After you have established the amount of risk-per-trade you are willing to take and the price level of the stop-loss, you will need to ascertain what position size will be suitable to ensure that you do not cross the risk boundaries. This can be easily calculated by following three simple steps:
Step 1: Ascertain the risk-per-trade ratio
Determine the percentage of capital you are willing to risk in a single trade. For example, if you wish to risk a maximum of 1% of your trading account and have a capital of $10,000, then your risk-per-trade will be $100.
Step 2: Determine the price of your stop-loss order
In the next step, you will have to determine the stop-loss order size. To do this, you can use chart stops and find a major resistance or support zone. For this example, let us consider your stop-loss order to be 50 pips.
Step 3: Ascertain the Position Size
When you finally have the two necessary ingredients, it is time to calculate the suitable position size. To calculate this, you simply need to divide the risk-per-trade with the stop-loss order size ($100 / 50 pips). This will give you the ideal pip value for your trade. In this example, the value is $2 per pip. This means that you should consider a position size of approximately 0.2 lots.
These are the three simple steps that you should follow to calculate the ideal pip value, ensuring that the total loss of the trade doesn’t exceed the risk-per-trade desired by you; provided that the stop-loss order shuts the trade at the desired level. Moreover, one should pay attention to how the position size is impacted by the stop-loss order size – the greater the difference between the entry price level and the size of the stop-loss order, the smaller your position size has to be. Similarly, when the distance between the two is small, you can easily run a larger position while remaining within your pre-determined risk-per-trade levels.
We can use this table to know the pip value for a mini lot of 10,000. With most brokers, one Forex mini lot amounts to 0.1 in the Metatrader 4 platform. The table was correct in July 2019.