It’s A Game Of Risk Management
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Why money and risk management is the most critical element to a successful trading career
Before making a trade, we tend to focus so much on the indicators, tools, fundamental analysis, and everything else we like to combine in order to assure a perfect entry. But in reality, the only thing that’s going to determine whether or not we make money in the market is money and risk management.
At the end of the day, though it is not often the most talked about and stressed element of trading, money management is undoubtedly the most important and vital piece of making money from the market puzzle.
Importance of Managing you Money Risk
There’s one glaring difference between a new trader and a veteran trader.
The new trader thinks about how much they can make while veteran trader thinks about how much they can lose.
As part of this, the pro trader also knows that one of the keys to winning is losing gracefully. They know that managing their losses has as much to do with success or failure as anything else involved in trading.
It’s OK to Take a Loss
When we enter a trade, we have to be ok with taking on a loss.
When we accept that losses are part of the business, that’s when we can understand how important it is to identify and manage risk effectively. This means using protective stops whenever it’s useful and not letting emotions dictate our trading approach.
It’s also crucial to know our exit strategy before we enter so we don’t let greed or fear drive us to make decisions.
For every trade, you should determine your entry, identify your risk, and protect your potential profit.
Every. Single. Time.
A Flip of the Coin
Imagine flipping a coin. There is a 50% chance that it lands on heads and a 50% chance that it lands on tails. Let’s say we win $1 when we guess which side it will land on correctly and lose $1 when we’re incorrect.
This puts us in a position to break even.
So in order to be profitable, we need to win a higher percentage of the coin tosses or we need to make more when we’re right than we lose when we’re wrong.
Now imagine you win $2 when you’re right and lose $1 when you’re wrong. Rather than breaking even on your flips, this would probably result in being consistently profitable.
Profitable traders take a similar position. There’s no guarantee that every trade will be profitable but over the long run, they know that they will profit. It’s easy to remove emotions when you take this wider, long term approach.
Have two big goals in mind while managing your trades. Try to win at least half of the trades and use the classic 1:2 risk-reward ratio. Make more when right than you lose when you’re wrong.
But what if the market reverses before hitting the profit target? We recommend moving protective stops once the market moves halfway to your target. This will allow you to break even or even escape with a profit.
A Whole Lotta Lots
If any of you are struggling with the question of how many lots should you open, here’s a handy little scenario and formula to consider:
You have an account size of $5000. You place a 25 lot trade on the euro/dollar which is 250,000 units. You’ve prepared for a 100 pip loss. At $25 each, this comes out to $2500.
Now it doesn’t make sense to risk half of all your money on a single trade. If the trade doesn’t work out immediately, you could quickly lose your entire account quite quickly.
The goal is to risk a limited number of pips in order to continue trading while allowing other trades to develop. Ideally, you shouldn’t risk more than 5% of your account size on any given trade.
This doesn’t mean you can risk 5% on multiple trades, however. For example, if you risk 5% on 5 trades, you’ll end up risking 25% of your account balance overall. Keep the overall account risk at 5% or less.
How to Craft a Great Risk Management Strategy
For this section, we’re going to use the percentage over your account balance method.
Before you start, know what percentage of your account you’re willing to risk. In our opinion, 2-3% is ideal, with 4% at the very most.
Assume we’re risking 3% of our balance and we have a $10,000 account balance
Therefore, 10,000 x 3% = total risk capital per trade of $300.
Decide where to place your stop loss for each trade.
A fictional asset has a $30 entry and we place the stop loss at $29.50.
If the price drops below $29.50, we want our stop loss to automatically kick in because we’ve determined the trade no longer represents a good opportunity for us. We’ve determined that the exit point is $0.50 stop loss total.
Position Sizing is determined by your risk management strategy. We decided in step 1 that we had $300 of total risk capital per trade and in step 2 we decided that for this trade we’d risk $.50 per share.
Step 3 is determined by taking the $300 and dividing it by $.50. This means we’re capable of buying 600 shares in this particular example without taking on excess risk. Small risk but a large pool of capital.
This final one calls for an honest and clear assessment of yourself and the risk you’re comfortable taking one.
How many positions can you hold open at once?
What is the maximum amount of weekly drawdown that’s acceptable?
What is the maximum monthly drawdown willing to take?
What is the maximum amount of drawdown before you say it’s not working?
Once you see the big picture and implement a long term, cohesive money management strategy, that’s when you’re career as a successful trader really kicks into high gear. Consistent returns based on well-crafted plans stemming from careful management will open the door to a long and lucrative career.
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