What is Risk Management?
It is a combination of multiple ideas to control your trading risk. It can be limiting your trade lot size, hedging, trading only during certain hours or days, or knowing when to take losses.
Why is it important?
It is one of the three pillars of your forex trading plan which ensures your survival as a forex trader. It is an easy concept to grasp for most of the forex traders but not as easy to apply in real life trading. Most forex traders tend to start trading with the mindset that they should aim for massive profits and they would need to risk huge proportions of their capital in order to achieve it. And some of the traders who perform demo trading think that it is easily replicable when he trades live. However, without a strong emotion management system, volatile emotions become rampant and things change. This is where a true risk management system becomes important.
One aspect of the risk management system is about controlling your losses i.e knowing when you need to cut your losses on a trade that has gone awry. In this instance, you would have the option to a hard stop or a mental stop. A hard stop is when you set your stop loss at a certain level as you initiate your trade. A mental stop is when you have set a limit to how much paper loss you are willing to tolerate before taking a trade.
Figuring out where to set your stop loss depends on the forex trading systemthat you adopt. Both the Black Dog System and Forex Trading Made EZ have a risk management system that advocates a stop loss which reasonably limits your risk on a trade. Once you have placed your stop loss, you need to be disciplined not to move it. It is easy to fall into the trap of moving your stop loss farther and farther out. If you do this, you are not cutting your losses effectively and it will ruin you in the end. This is an aspect of the emotion management systemthat is very important. If you find that you would need reinforced discipline in your emotion management, MyTradingSoftware would be able to help. Another option of avoiding such traps would be to use a forex expert advisor or forex robot. As the trades are automated, it removes the emotion management aspect and ensures that all trades being opened and closed are devoid of the emotions of fear and greed.
Using correct lot sizes
Calculating Position Sizes
The promise of instant riches is difficult to resist for most forex traders. It is this very reason that many people from all walks of life begin their forays in the forex market. Although it is also important that you do have the mentality of always aiming for a high return on your investment, a forex trader should really focus on the more important aspects of trading first such as emotion management and risk management. When a forex trader contemplates any set up for a trade, he must be psychologically prepared that no matter how perfect the setup would seem to be, anything can happen and things can go wrong resulting in the trade being a loser. A successful forex trader must be able to take the loss in stride and live to trade another day. This is just a part of what every trader may have to go through on a normal trading day.
So how do you ensure proper and safe risk management? The answer should come from your money management rules and most forex traders usually define it as risking less than 2% of their accounts on any one position. But of course, it need not be 2%. This percentage is usually defined by the trading system that you intend to use.
How then do you ensure that only Y% risk is taken on your account? What many beginner forex traders believe they should do is to use Y% of their margin on every trade. This totally contravenes with the principles of proper risk management and is extremely dangerous. So what should be done really is to ensure that the calculation takes into consideration the trade set up. The trade setup is the critical factor that determines the positions size and not the other way around. This is one of the most important aspects of risk management in retail forex trading, and many traders simply don�t fully understand it (or don�t really bother with it). Let�s use the following example to illustrate this.
Let�s consider a scenario that you have a US$10,000 mini account with an MT4 broker that allows you to trade 0.01 lots (minimum trade size would be 0.01 x 10,000 = 100 units). The margin requirement for your forex broker is 1% or also stated as maximum leverage of 100:1. Now let�s say that the current price of GBP/USD is 1.5600 and you see a nice trade setup developing. You decide that you would want to go long at 1.5500 as it is a strong support level and your analysis indicates a strong likelihood of price appreciation from there, should price go to 1.5500. Your analysis also indicates that if the currency pair was to drop below 1.5050, the trend would be considered as unfavorable and that the trade should be exited with a stop loss order. You also place the exit target at the next resistance level at 1.6500. You then place your buy limit order at 1.5500, but before you do, you would need to figure out the optimal position size. How much do you want to buy at 1.5500?
he incorrect way:
You were told that using 1% of your available margin is the same as risking 1%. You do a quick calculation and you see that your position should be 1 mini lot, or 10,000 units of GBP/USD. You decided to enter your buy limit order at 1.5500, with a stop loss at 1.5000
Unfortunately, after you have entered the trade, the British economy started to show some weakness in the coming weeks and your support level was not able to hold. GBP/USD eventually exceeded your stop loss level and the trade resulted in a loss. From your initial expectations, you would have considered the US$500 loss as acceptable as you thought that you were risking just 1% of your account. However, US$500 is not 1% of your US$10,000 account but actually 5%. So what is the correct way of calculation?
The correct way:
The above example has illustrated the difference between the �used margin� and �amount at risk�. The amount at risk is the amount you stand to lose if price hits your stop loss. Here is how you calculate:
Y = (R X B)
Z X (Pe – Ps)
Y is the size of position we are trying to calculate (in units of the base currency)
R is the % of account you intend to risk
B is the balance of your account
Z is the buy (long) or sell (short) factor: -1 if (sell) short position, +1 if buy (long) position
Pe is the entry price
Ps is the stop loss (exit) price
You would need to substitute the values and this is what we will get.
Y = (1% X $10000)
1 X (1.5500 � 1.5000)
= 2,000 units
So we now know that the ideal position size for our desired setup would be 2,000 units of GBP/USD. We know that all currency pairs with USD as the counter currency have constant pip values of $1 per 10,000 units. Hence, a position of 2000 units would have a pip value of $0.20 and if were to multiply this by 500 pips, we would get a $100, which is 1% of our $10,000 account.
Please note that the above formula will only be applicable for all USD/ABC and ABC/USD pairs. It cannot be applied to crosses where there are no USD references (ABC/XYZ), such as EURGBP, GBPCHF and AUDJPY because the pip values for crosses depend on the underlying USD/ pair�s price.
Tracking overall exposure
It is also important that you keep track on your overall exposure to the forex markets. Although, using small lot sizes will help you in risk management, it will simply defeat the purpose if you open too many small lots.
In addition, it is also important to understand correlations between currency pairs. For example if you are in short position on GBP/USD and also in a long position on USD/CAD, you are actually exposing yourself twice to the USD and in the same direction. It equates to being long 2 lots of USD.
Hence, being aware of your overall exposure will reduce your risk and keep you in the game for the long run.
The bottom line is that risk management is all about controlling your risk. The more you can control your risk ,the more flexible you can be when the situation calls for it. Most forex traders will agree that forex trading is about opportunity and that traders must be able to act when these opportunities arise. By limiting and controlling your risk as directed in your risk management methodology, you ensure that you will be able to continue to trade when things don�t go as planned and you will always be ready for the next trade setup.