RISK MANAGEMENT - Lesson 4
In this lesson you will learn:
- The importance of Risk Management
- How it is applied in a Trading Strategy
The management of our risk, through the application of strict and disciplined money management technique, is the bedrock and provides the foundations, to allow us to construct our trading plan and strategies. As has been discussed many times, out of the various elements required to build effective trading plans and the strategies contained within, money management is the key. No effective trading strategy can possibly work without precise money management.
It plays a significant role in traders’ decisions and can be used as a tool to limit the risk of the overall portfolio.
Successful money management depends on the crucial five steps:
- Risk ratio
- Risk to reward ratio
- Maximum drawdown
- Proper position size
- Trade Management
When talking about the Risk ratio, a trader must determine how much he/she is willing to lose per trade, and depending on the trading style, one should not risk more than 5% per trade, of the account equity. However, the 2% rule became more popular now-a-days, where not more than 2% of capital should not be exposed to risk of loss. Being more cautious and having a lower percentage to risk per trade will lead to have a higher equity at the end of the day.
In addition, stop loss levels should be defined and the reward should always be two or three times higher than the risk. Stop losses come in various guises; trailing stops, dynamic trailing stops, hard stops, disaster stops and mental stops. All have their uses and in theory you could protect yourself from many situations by using a combination of several.
We could combine this trailing stop with another emergency stop, a stop below the trailing stop, which protects us from any outlier. This could also be a mental circuit breaker stop, at which we effectively pull the plug on all our trades, if we find ourselves the wrong side of the market, when a black swan, or event horizon disaster occurs in the market.
The maximum drawdown refers to the reduction of the trading capital after a series of consecutive losing trades. Therefore, it is important to limit the total risk to which the trades are exposed to, as well as emotional discipline to overcome the drawdown periods.
Furthermore, determining the proper position size depends on the capital the trade has and the trading plan. Knowledge of volume and how to determine the correct trade size is the key to maximize the results. It is of great help to use the position calculator in order to make sure that a uniformed trade decision is taken.
If we use as an example a $5,000 account and we only want to risk 1% of our account on EUR/USD, then we use a simple calculation to risk only 50 dollars on each trade.
USD 5,000 x 1% (or 0.01) = USD 50
Then, we’ll divide the amount being risked, our $50, by the stop we’re prepared to use, in order to find the value per pip. Let’s assume we are using a significant stop level of 200 pips.
(USD 50) / (200 pips) = USD 0.25/pip
Finally, we’ll multiply the value per pip by the known unit/pip value ratio of EUR/USD. In this instance with 10k units (or one mini lot), each pip move is worth USD 1.
USD 0.25 per pip (10k units of EUR/USD) / (USD 1 per pip) = 2,500 units of EUR/USD
Therefore we would put on 2,500 units of EUR/USD or less, in order to stay within our risk parameters or comfort level, which we’ve decided was a 1% tolerance, with our current trade setup.
The last but not least is the trade management. A trader must develop a trading plan, which will include the trading stops and emotional control - not to exit a trade without a strong reason. Following a trading plan increases the odds of having profitable trades and minimizes mistakes.
