Risk management is probably the most important aspect of your trading activities. 90% of all traders fail in Forex and this is the number one reason why traders fail because they don’t have a proper risk management protocol. Losing trades are part of the business and as soon as you realize this the better.
The reality is if you understand proper risk management you can actually lose more trades than you win and still come out very profitable if your risk to reward ratio is bigger than 1:2. The risk management should be the cornerstone of every investment strategy. If you want to learn more on how do build a Forex strategy read our previous article 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. Basically, risk management 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 so when you understand one you’ll pretty much understand the other. The Margin is basically a good-faith deposit that you have available in your account equity against potential losses when you’re holding a position.
Leverage is like a huge loan that allows you to control a bigger position than what you have as equity in your trading account. In order to understand the minimum required amount of cash that you need to have in your account in order to hold an open position, we’ll be going through an example and see how it relates to leverage.
- 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
The most important thing to keep in mind about leverage is that it’s a double-edged sword because too much leverage can also increase the risk of losing your account entirely.
Risk and Reward
The risk-reward ratio is basically a ratio that compares the amount of risk or potential risk to potential reward. In essence, the risk-reward ratio tells you about the potential profitability and gives you a way to measure and analyze your trades.
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 simply the distance between entry and stop loss while the reward is the distance between your entry and take profit order.
Your risk-reward ratio will also tell 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 specifically refers to how much should you risk or how big any particular trade should be. Basically, position sizing 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 anyone trade, then our risk exposure in this particular case would be $200 (account size divided by % risk).
If we were to take a trade, for simplicity shake our maximum stop loss is 50 pips that would mean that each pip has roughly a pip value of $1 and we’ll have to use a position size o just 4 mini lots.
The position size will help you be very consistent and disciplined with your trading activities so when you’re making your trading decision you’re much less likely to make a mistake and you’re much more likely to get in with a size that is consistent with your risk tolerance and analysis.
You have to think of yourself and have the mentality of a risk manager first and a trader second. By now, hopefully, you understand why risk management is the most important factor in determining your success or failure as a trader yet is completely overlooked by most new traders. Taking risk is part of trading and as long as you can quantify the risk you can manage it.