By: Nial Fuller
Risk management is a topic that many forex traders do not take seriously enough. In fact, risk management is probably the single biggest factor that is over looked amongst forex traders and this is the biggest reason why 95% of them fail to make money over the long term. The reason that so many traders ignore managing their risk or developing a risk management plan is simply because they don’t feel like they need to. Many forex traders think that their system or their trading method is so accurate that they don’t need to manage their risk because they believe they will win on a very large percentage of their trades. The truth is that this is a false belief and it is simply emotional trading and illogical thinking as a result of fear and or greed. Professional forex traders understand that at best they will win on 60-70% of their trades, they understand they will lose on any where between 30-50% of their trades. If you knew you were going to lose something 50% of the time why would you not manage your risk? The simple answer is because novice forex traders do not understand the concept of position sizing and they are trading based off emotion.
Position sizing is simply adjusting the number of lots or contracts you trade to stay within a pre-defined risk threshold while placing your stop loss at a safe level. Let’s dig into that sentence piece by piece. Many traders make the huge mistake of having a certain dollar amount in their mind that they are willing to risk before they enter a trade. They then buy or sell a number of lots that is equal to or greater than that dollar amount of risk. After that they will arbitrarily put their stop loss in mainly because they have heard you should trade with a stop loss. This is not an effective risk management scheme, in fact it is basically gambling but it is exactly how, or similar to how most forex traders enter a trade.
To effectively utilize the power of position sizing you must first understand that it is absolutely necessary to have a set risk percentage that you are emotionally ok with losing on any one trade. Most traders cannot operate emotion free after losing more than about 3% of their account value on anyone trade. As such, risking 2% or less is the recommended amount for any trader and you will be hard pressed to find any professional short-term or swing forex trader risking more than that on anyone trade, this is because they understand the importance of risk management and have already lost enough money to know they cannot control the market. So now your risk is at 2% of say a $5,000 dollar trading account. This means you can risk $100 on any one trade that meets your criteria for a valid trade setup.
So here is where position sizing, risk threshold and stop loss placement come in. Once you find a trade that meets your trading plan entry criteria you then need to find the safest place for your stop loss, after you find this level you calculate the distance between it and your entry level. Let’s say this distance is 150 pips, this means you can still only risk $100 but you must now adjust your position size down to meet your risk threshold. An advantage to forex trading is that you can trade mini and micro-lots at many brokers which essentially means you have extreme flexibility in position sizing. So to meet your 2% risk threshold and maintain your 150 pip stop loss distance you can only trade 0.66 micro lots, which means you are trading .66 cents per point. .66 x 150 = $99. It’s important to stay just under your risk threshold if it comes down to being slightly under or slightly over; if you traded.67 cents per pip you would be risking .67×150=$100.50, which is over 2% risk, you want to avoid this because it will induce an emotional reaction that will very likely snow ball into a huge emotional roller coaster of trading errors.
About the Author
Nial Fuller is a Respected Trader and Forex Coach. He runs a Forex Training and Education Website, Visit his site here Forex Risk Management
(ArticlesBase SC #1821380)