Chapter 1 : What is risk management in Forex?
Risk management… One of the most important topics when it comes to Forex trading. Why? Well, you are in the Forex business to make money. And to make money, you have to learn how to manage your losses and eliminate the risks.
But ironically, this is one of the most neglected areas of Forex trading. Many traders are just too excited to get started and completely disregard their account size.
But there’s a term for this type of investing it is not called trading. It’s GAMBLING!
And when you gamble, you’re looking for a jackpot not a long-term return. Just like when people go to Las Vegas to gamble their money in hopes of winning a big wad of cash…And don’t get me wrong, even if Andrew Lockwood does win the $500,000 jackpot, the casinos know that there will be thousands of other players who won’t. And that’s essentially how casinos manage to stay in business. They profit from the people that don’t win. So… how do you become the 1% of the traders that do win?
What is Risk Management?
In finance, risk is defined as the potential for the actual return on investment to be lower than the expected return. This includes the potential for loss and – if you’re trading using leverage – the potential to lose even more than you put in.
Risk management can then be defined as a set of rules and measures you can put in place to ensure the impact of getting a decision wrong is manageable. At the end of the day, Forex is a numbers game. And in order to win, you have to tilt as many factors as you can in your favour.
You want to be a part of the 1%, NOT one of the gamblers because, in the long run, it’s always better to be a consistent winner.
Chapter 2 : What are the best ways to manage risk in Forex?
It takes money to make money. But how do you know how much money is enough money? And how do you know how much money is too much money (to risk)? Let’s recap what we’ve learnt in the previous chapters on how to manage risk in Forex.
1. Always do the maths
Before you place a trade, it is important you always calculate how much you could to lose in the worst case scenario. You never know, the market can move quicker than you thought or gap, or million other things that can prevent you from getting out of the trade at the level you wanted to.
This is super important to remember especially when using leverage as your losses could be bigger than your deposit.
2. Ignore your emotions
It is important you distinguish between rational and emotional decisions when trading.
Making decisions based on your gut feeling will most likely end in disaster, so it’s crucial you back up your decisions with analysis. Just make sure, You will not trade based on emotions or gutfeelings.
Don’t put all your capital into a single currency pair. Why?You might lose it all if the market goes in the other direction. Instead, keep your options open with other currency pairs. Then, your losses won’t have such a devastating impact on your overall trading account.
Okay, so now that we have looked at some general methods of managing your risk, let’s discuss two techniques you can use to figure out how much risk you should be taking on with every trade you place.
4. Calculate how much you want to risk
Choosing how much to risk per trade is completely up to you. You will find traders that advise not to risk more than 1% of your trading capital per trade, while others say it’s okay to go all the way up to 10%.
However, most traders do agree that going anywhere above that would be MAD. Why?
If you go on a big losing streak, the amount you are risking per trade will have a huge effect on your capital and the ability to claw back your losses.
Say you’ve got $10,000 on your trading account and so it happens you lose 15 trades in a row.
Here’s the difference between risking 2%, 5% or 10% per trade:
- With 2% risk per trade, even after 15 losses you’ve lost less than 25% of your trading capital. You can still win easily your money back!
- However, with 5% risk per trade, you’d have lost over half your initial trading capital. You’d have to win more than double this amount to get to your original level.
- With 10% risk per trade, things are even worse. You’d be down over 75% making it extremely difficult to make back the money you’ve lost.
The reduction of capital after a series of losing trades is called a drawdown but more on that later.
You can also work out a risk-per-trade scale. It might look like this:
Remember, all traders will be affected by a losing streak at some point, but the ones who plan their trading to cope with those streaks are usually more successful in the long run.
5. Work out the risk vs reward ratio of every single trade
The truth is that it is possible to lose more times than you win, and yet still be profitable.
It’s all down to risk vs reward.
For example, if your maximum potential loss on a trade is $300 and the maximum potential gain is $900, then the risk vs reward ratio is 1:3.
If you stick to these 5 rules, the chances are you can make it as a Forex trader.
Chapter 3 : Drawdown and Maximum Drawdown Explained
As we touched on in the previous chapter, risk management can make you money in the long run if you approach it with a good strategy and patience, but it is not all unicorns and rainbows.
It may not be as pretty, but it is crucial you understand the risks each and every trade can carry.So let’s say you didn’t use risk management rules. What could happen?
For example, let’s say you had $200,000 and you lost $100,000.What percentage of your overall balance would you have lost?
The answer is 50%. This is what traders call a drawdown. Your account has experienced a $50,000 drawdown.
A drawdown can be defined as the reduction of one’s capital after a significant amount of losing trades.Or in other words, it is the largest amount you lose before you start making a profit again.
Let’s explore some of the biggest causes of drawdowns…
- Poor risk management rules
- Fear of losing money
- Trading with too much leverage
What You Can Learn From a Drawdown
When trading, we traders are always looking for an EDGE.After all, it is one of the main reasons why we develop strategies and systems.Sure, a trading strategy that is 80% profitable sounds like a pretty decent edge to have.But just because it is 80% profitable, it doesn’t mean that you will win 8 out of every 10 trades.You could lose the first 20 and win the other 80 trades.
That way, it is still an 80% profitable system but it does raise some questions. For example, would you stay in the game if you lost 20 trades in a row?
And this is exactly why it’s crucial to have your risk management in place!
No matter what system or strategy you use, you will at some point experience a losing streak. There is no avoiding it. Even the best out of the best Forex traders have their losing streaks, and yet they still end up profitable.
Why?Because they only risk a small percentage of their trading capital.This is simply what you must do to succeed in such a vibrant and ever-changing market.
Drawdowns are a part of it. Deal with it.
The goal is to come up with risk management rules that will enable you to survive these periods of bigger losses. Remember, if you practice and stick to your Risk Management rules, the chances are you will become a part of the 1%.
Chapter 4 : How much should you really risk per trade?
Well, the most popular answer is to try to limit your risk to 2% per trade.
Never Risk More Than 2% Per Each Trade
But even that might be a little high for newbie Forex traders.But don’t take it from me, take it from the stats.
Just take a quick look at this table that shows the difference between risking 2% of your capital per trade compared to risking 10% percent.
It’s clear to see that there’s a huge difference between risking 2% vs risking 10% of your capital on just a single trade.
Just imagine you hit a losing streak and lose 15 trades in a row, risking 10% on each trade. If your starting balance was $20,000 then you would only be left with $4,575.That’s over 85% of your account gone. Boom. Just like that.
However, if you only risked 2% on each trade, you’d have only lost 30% of your total account and you would still have $13,903 in your pocket
I know, I know. You don’t even want to think about losing 15 trades in a row.The truth is, the difference would still be significant even if you had only lost 5 trades in a row.The point we are trying to make is that it’s crucial you set up your risk management rules in a way that even when you do hit a drawdown, you will still have enough $$$ to stay in the game.
Can you imagine losing 80% of your account balance?!!You would have to make a 400% profit of your remaining balance to just break even.
In the table below, we’ll look at a number of different examples that show how much you’d have to make to break even if you were to lose a certain % of your account balance.
The more you lose, the harder it gets to get back to your starting capital…
We can’t stress this enough when we say PROTECT YOUR ACCOUNT.
PROTECT YOUR ACCOUNT
Only risk a small percentage of your account balance so that your world won’t come crashing down when you hit the losing streak!
Chapter 5 : What is the best risk reward ratio in Forex?
The risk-reward ratio measures your potential reward for every $$$ you risk.
Let’s talk examples. For instance, say you have a risk-reward ratio of 1:5, you’re risking $1 to potentially make $5.
Or say you have a risk-reward ratio of 1:10, you’re risking $1 to potentially make $10.
Pretty straight forward right?
But what’s the recommended risk reward ratio in Forex?
What is Risk and Reward in Forex?
To put it simply, risk is the total amount that could potentially be lost from a trade.
Reward is the potential profit you could gain from a trade.
The risk/reward ratio is the relationship between these two numbers.
Now that we got the definition out the way, let’s talk business.
How is the Risk:Reward Ratio calculated?
To calculate the risk & reward ratio, you’ll first have to establish each og them separately.
The formula goes like this:
If the ratio is more than 1, the potential risk is bigger than the potential reward.
If the ratio is less than 1, the potential profit is bigger than the potential loss.
Take a look at an example below to see the different risk:reward ratios on a Forex chart.
What is the recommended ratio?
Many experts and Forex traders believe that if you want to increase your chances of being profitable, you want to trade with the potential to make 3 times more than what you are risking.
This theory suggests that trading with 3:1 reward-to-risk ratio is the right way to go about trading Forex!
Let’s see what this would look like in practice by looking at the table below.
You can clearly see that even if you only win half of your trades, you will still end up profitable at the end.In fact, you’d bag yourself $10,000.
Now, you might be wondering why all traders wouldn’t just go with higher reward to risk ratios.It’s simply because it is more difficult for the price to reach a higher profit target than it is to hit the stop-loss level.At the end of the day, your trades need breathing room to cope with all the price fluctuations!
Don’t risk too much money trying to make big profits fast.Be smart and be patient. It will pay off!
Chapter 6 : Study Your Losses to Realise Gains
Rule #1 in trading is to NEVER EVER ignore your losing trades. And by NEVER EVER we mean NEVER. EVER. Seriously. Never.It’s these losing trades you can learn the most from. Let’s go through the different ways to learn from them together.
1. Calculate your trades
To get started, we would suggest you to look up your past trade transactions. Specifically, take a look at your profits and your losses.
First, we are going to calculate your Average Gain.
Next, we are going to calculate your Total Loss.
Once we have calculated both, the average gain and the average loss, let’s display is as a ratio.
For instance, if you had 20 winning trades, bagging yourself an average of $300 per trade and 10 losing trades, losing $400 per trade on average, this is how you’d go about it to calculate it.
Profit / Loss Ratio = 0.75
This then means that your average profit is 75% your average loss.
Fortunately, you won 20 trades out of 30.
Your winning percentage was 75%.
Win % = 20 / 10
Win % = 0.75 or 75%
The average win compared to the average loss also tells you how well you’re managing and closing your positions.
2. Pay attention to your losing trades
To learn from your mistakes, you need to pay super close attention to your losses. It is about how you manage and control your losses that can make or break you as a Forex trader.So my question to you is, have you ever found yourself in a drawdown?
Now would be the right time to sit back and reflect on how you acted. This way, you will be able to identify the bad habits in your trading approach and eventually step back from them. Chances are, you will grow as a Forex trader!
3. Manage your expectations
Expectancy in Forex is the average amount you expect to win or lose per trade based on your previous performance.
For instance, let’s say 40% of your trades in the past two months were profitable and you won $400 per trade on average, while 60% of your trades were unprofitable with an average loss per trade of $200. This is how you would calculate it.
($160) – ($120)
Expectancy = $40
And believe it or not, your trading performance does depend on your expectancy.
Wrapping Up,Going back and reflecting on your performance regularly can help you better understand your wins and your loses.It might not be the most interesting exercise, but it does work.And who knows, maybe in time you can turn your loses into profits!