Risk Management includes wise Money Management principles

Chris Lee

To be successful at forex trading, we are told from the beginning that one must approach the market in a disciplined manner. This oft-repeated mantra has meant that you must develop a step-by-step plan for both entries and exits in the market, practice that plan on a demo system to render it to habit, and to tilt the odds in your favor by using technical indicators, recognizing patterns, and noting key levels of support and resistance. This rather hefty mouthful of guidance is not the end of it either. Veteran traders, the successful ones that make real money at this craft, are also ever vigilant at managing risk through the use time-honored money management principles.

Once again we have a step-by-step approach that will bring discipline to the way you trade and produce benchmarks for measuring your success. You do not have to be a scientist or have a PhD in Physics to apply these simple rules. We advise you to keep it simple and to follow the following four steps: 1) Risk/Reward Assessment, 2) Position Sizing Rules, 3) Stop-Loss Placement, and 4) Take-Profit Placement.

Risk/Reward Assessment

The objective here is to pick your targets for both potential loss and profit before you ever execute an order. The average trader will spot what he believes is a good trend or reversal forming and jump into the fray. The wiser course of action would have been, in the case of a rising trend, to observe initially where the first resistance level might come into play. If it was 125 pips out, then you might set a targeted profit of 120 pips.

The next question you have to ask yourself is how much are you willing to lose on this trade. The rule of thumb for experienced traders is generally a ratio of 2:1 or 3:1, which means they expect their reward to be at least 2X or 3X times their potential loss. In this hypothetical trade, the allowable loss for a 3:1 ratio would be 40 pips, or one-third of the targeted gain. This 40-pip figure will then be used in the next two steps.

Is there another way to set targets? Depending on your preferred time period, some traders use the “Average True Range” (“ATR”) indicator for this purpose. Set the ATR for 20 periods. On a “Daily” chart for the “EUR/USD”, the ATR may read 120 pips for a 20-period average. Your profit target becomes 120 pips, and your loss limit is 33% or 40.

Position Sizing Rules

Retail forex trading is all about measured speculation. It is not about gambling, although many newcomers regard it as such. In a casino, gamblers often employ what is known as the Martingale strategy. If the House odds are near 50/50, then after any loss, you double your position size and keep doing so, until you win your money back. Of course, you do need unlimited capital, and casinos are not dumb – they have placed size limits on bets to discourage this type of approach.

In the world of forex trading, losing streaks can happen, and Martingale will not save you. Long losing streaks have even happened to veterans, but they know from experience when to step away from the table or how to protect their downsides so that they can come back to win another day. The first step in their process is to control their position sizes according to a strict mathematical constraint, euphemistically referred to as the “2%/6%” position sizing rule.

For example purposes, let’s assume that you have $5,000 in your account and that you frequently use the 50:1 leverage available from your broker. The “2%” when applied to your account balance is equal to $100. This figure is the loss limit that you should set for this trade. Divide that by 40 pips (0.004) to get $25,000, and divide that by 50, your leverage, to arrive at $500, your optimal position size wager. Your broker may require you to enter a lot size on your execution order, so you may have to perform one more calculation, i.e., the $25,000 amount is equal to a 25% lot size.

What about the “6%” part of the sizing constraint? The rule here has to do with how many open positions you have at any one time in the market. If your position sizes follow the 2% rule above, then the guidance is that you should never have more than three, or 6% of you capital, of ongoing trades in the market.

Stop-Loss Placement

Veteran traders also swear by stop-loss orders, the other step for protecting their downside risk. In our example, the 40-pip figure becomes the stop-loss level that should be set when your order is executed. Many traders avoid this step to prevent the broker from “stop-loss shopping” during ranging periods, but one bad experience will cure you of this high-risk practice. Also remember that stop-loss orders may not be guaranteed during high volatility. Check your broker agreement for disclaimers.

Take-Profit Placement

Another adage in trading is that paper profits are nice, but you do not really have profits until the money is in your account. There is a psychological benefit to seeing the money tucked safely away in the bank. Traders will often take down 50% of their gain when or before their target is reached, and, at the same time, move their stop-loss order accordingly. A trailing stop-loss order is a bit more complicated, but it achieves the same objective in real time.

Concluding Remarks

Money Management principles may seem overly complex, but once practiced, they will become routine and almost second nature to you. Add them to your repertoire, and you will become a successful trader.

Chris Lee

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