# An Alternative Way to Manage Risk in Forex Trading

05/29/2013 9:00 am EST

Focus: FOREX

One of the key components of a good trading plan has to be the risk reward ratio for each specific trade, and the staff at ForexTraders.com details how you can calculate it so you can tell whether your risk is under control at all times.

Without complicating the subject too much, and engaging in a discussion which may generate results that are inapplicable in the context of the common tools possessed by a retail trader, we can identify three variables in the equation that determines how risky a hypothetical forex portfolio is. By risk, we focus on the maximum drawdown our portfolio may have to survive, if matters don't progress in the anticipated direction. The variables in question are leverage, trade size, and volatility. Since the total return is dependent on leverage and trade size (both of which are determined by the trader), and on the volatility of the initiated trade (which is unknown, and determined by the market), it is not difficult to see that these three provide a simple yet effective definition of risk.

Mathematical Description of Relative Risk in a Forex Portfolio
Proceeding from the above reasoning, we can reach at a mathematical description of the risk assumed in a forex portfolio. It is important that our forex portfolio not be heavily skewed toward any currency pair. For instance, the distribution of currency pairs is more like 60% EUR/USD, and 40% USD/JPY, and not 90% USD/JPY, and %10 USD/CHF.

Relative Risk = (Leverage x Trade Size x (Average Volatility of the Portfolio/Volatility of S&P 500))/Account Equity

We take not the volatility of a pair itself, but the ratio of its volatility to the volatility of EUR/USD or S&P 500 for the purpose of reaching a definition of relative risk. There is no credible relationship between historical and future volatility, so assessing risk on the basis of past patterns would not be very useful. It is possible to assume, on the other hand, that even as volatility itself changes, the relationship between the volatilities of two currency pairs changes slower, due to the underlying fundamental factors that determine it. Using this approach may allow us to gain an idea on how risky our portfolio is in reference to a base pair, which we regard to be highly liquid and reasonably stable.

NEXT PAGE: An Example in Carry Trading

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We prefer this ratio to remain as small as possible. We also want to determine a ceiling value for it, so that the risk of trades that we initiate does not breach a predetermined value. Needless to say, it is not very sensible to identify a numerical value, and to claim that all trades stay beneath that ceiling, in order to maximize returns and minimize risk. But while it may not be possible to achieve that purpose, we can use the relative risk ratio (RRR) to create a plan for reducing or increasing the riskiness of our portfolio depending on the trading strategy that we employ.