Risk management is probably the most important aspect of your trading activities. 90% of all traders fail at Forex trading – this is the number one reason why traders fail. They fail because they don’t have a proper risk management protocol and don’t understand that losing trades are part of the business and as soon as you realize this the better.
In trading, you can actually lose a higher number of trades than you win and still have a profitable account, just as long as your risk to reward ratio is greater than 1:2. Risk management should be the cornerstone of every investment strategy. If you want to learn more about how do build a Forex strategy read our previous article on how to develop an investment strategy.
What is Risk Management?
Risk management is knowing exactly how much money you can lose at any particular time because you have pre-calculated this number. It is an attempt to assess the potential loss in any trade and then take the right measures based on your risk tolerance.
Margin and Leverage
Margin and leverage are functions of each other. The Margin is basically a good-faith deposit that you have available in your account equity to guard against potential losses when you’re holding a position.
Leverage acts like a loan, which allows you to control a bigger position than the equity you have in your trading account. A trader needs to be able to calculate the minimum required amount of equity that is needed in order to hold an open position to cover for the leverage used in the trade. Here is an example of how this is calculated.
- Currency Pair: EUR/USD
- Position Size: 100,000
- Leverage Ratio:1:100
- Margin Required = (Price * Position Size) * Leverage = (1.0450*100,000)*0.01 = $1,045
From a risk perspective, leverage is a double-edged sword because applying too much leverage can also increase the risk of losing your account entirely, and using the right amount could make for a very profitable trade.
Risk and Reward
The risk-reward ratio shows the amount of risk, or potential risk, against the potential reward. In essence, the risk-reward ratio outlines potential profitability and gives a trader a way to measure and analyze trades potential.
In order to determine the risk-reward ratio, you have to know where you’ve set your stop loss and take profit orders. The potential risk is the distance between entry and stop loss, while the reward is the distance between your entry and take profit order.
The risk-reward ratio tells you exactly how big your win-rate has to be in order for you to make money as a trader. For example, when your risk-reward ratio is 1:1, it means that your win rate has to be over 50% to make money long-term.
Position sizing refers to how much you risk your trades have, or how big your trades should be. It takes into account three things:
- Account size;
- How much risk or percentage of your account are you willing to risk on each trade;
- Stop loss.
As an example, we’re going to use a hypothetical account size of $10,000 and let’s suppose we’re going to take a maximum exposure of 2% on any one trade. Our risk exposure would be would be $200 (account size divided by % risk).
In order to decide on the portion size we should take in relation to our risk strategy, we do the following. Let’s say our maximum stop loss is 50 pips (which would mean that each pip has roughly a pip value of $1) and we’ll have to use a position size of 4 mini lots.
Calculating position size will help you be very consistent and disciplined with your trading activities. This way when you’re making a trading decision you’re much more likely to get in with a size that is consistent with your risk tolerance and analysis.
In order to get risk management correct in trading, you have to think of yourself as a risk manager first and a trader second as your risk tolerance will determine your success or failure as a trader. Taking risk is an integral part of trading, but the risk needs to be managed and the trader needs to be aware of the risk exposure levels in every trade.