How to Manage Forex Risk Like a Pro

06/18/2010 12:01 am EST

Focus: FOREX

In terms of money/risk management, a general rule of thumb is to predetermine a max percentage of total account equity that one is willing to risk (1%-3% is typical, for example). The benefit of this discipline is twofold. First, this prevents "heavy losses" occurring from any single trade since the size of each individual position would be adjusted to fit within this maximum percentage risk of total equity. (The term "heavy" is rather subjective since we all have different levels of risk tolerance, which goes back to determining the maximum percentage risk of total equity per trade.) Second, this type of discipline would also prevent heavy losses during a losing streak, which, realistically speaking, is somewhat inevitable even for some of the most successful/experienced traders.  For example, risking a max of 3% per trade would mean that you would need to lose about 33 trades in a row to bring total equity to zero.

Once the amount of risk (in pips) has been determined for a particular setup (meaning the anticipated entry and stop-loss placement has been established), the position/lot size can then be calculated accordingly. For example, let's assume one of our trade recommendations carries 47 pips of risk with a pip value of $8.52 (based on standard 100k lot size). Let's assume, for the purposes of this hypothetical example, that a max of 2% of total equity will be put at risk on any single trade with a total of $10,000 in trading equity. This would mean no more than $200 may be put at risk on the next trade ($10,000 x 2%=$200). This also means that placing a single standard lot trade is out of the question, because 47 pips of risk times $8.52 pip value per standard lot equals $400.44 total risk, which is double the maximum percentage risk per trade! This is where "discipline" comes into play because a lack of this type of discipline tends to result in things spinning out of control and typically leading to heavy losses, even if only by a seemingly small amount like 2%, which, in trading reality, is a huge difference! However, this same trade setup may still be acceptable by adjusting the position size to five mini lots because 47 pips of risk times $0.85 pip value per 10K mini lot times five mini lots equals $199.75 in total risk, which is within the hypothetical 2% max.

The decision to enter then becomes a question of risk-to-reward ratio. In my experience, risk/reward far outweighs winning percentage, and is the oftentimes the deciding factor in whether or not to take a trade. Don’t get me wrong, winning percentage is important to know, but in no way, shape, or form does it indicate how “successful” a strategy—or an individual trader, for that matter—is performing. I think the reason why so many traders get wrapped up in winning percentages is because winning a trade means you've made money and losing a trade means you've lost money. So our focus tends to narrow to the last few trades as a way to measure success, and we then start to lose sight of the big picture. Even worse, we may get wrapped up in each individual trade, which tends to happen during both winning and losing streaks; either of which can be equally destructive (winning streaks oftentimes lead to overconfidence and deviation from strict risk/money management rules, whereas losing streaks oftentimes lead to desperation tactics with similar deviation).

What ends up happening is we get into the destructive (and perhaps humanly innate) habit of wanting to be “right” versus being “successful.” For this reason, many traders tend to take profits quickly in order to be “right” or get a “win,” which also leads to a habit of hanging onto losing trades for too long. This results in an unfavorable average risk-to-reward ratio, which may significantly diminish returns relative to winning percentage. In other words, it’s possible for someone to have a seemingly impressive 80% win ratio, but actually lose money over time. Conversely, a winning percentage of 30% may sound downright depressing, but may be extremely profitable. Consider the following…

- [80% win ratio] x [3-to-1 avg. risk-to-reward ratio] = 20% return
- [30% win ratio] x [1-to-3 avg. risk-to-reward ratio] = 20% return

There is only one way that I know of to truly measure trading success: Sustained profitability. This is why having a risk/money management plan (and the discipline to follow it) is an absolutely essential part of any successful strategy. Without it, in my opinion, sustained profitability is virtually impossible.

Roger A. Stojsic of GFTForex.com

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