Risk management is what separate professional traders from gamblers. Effective risk management strategies allow traders to minimize losses and increase the chances of staying in the game while scaling up winning trades.
The emphasis here should be not on having the best trading strategy but in building a strict risk management strategy to help you protect your capital and sustain your growth.
Having a proper risk management plan can make for safe, more controlled, and less stressful trading environment.
In this article, I will go through some of the fundamental components of a risk management strategy.
What is risk management?
By definition, risk management is the elimination of unacceptable risks. It’s the most important part of your trading education. Without strict risk management rules, your chances of success in this business are down to zero.
As retail traders, you have no control over price movements and even the best market analysts out there can be wrong in their forecasts.
However, it’s possible to control many other things: when to trade and when not to trade, what pairs to trade, when to exit a trade, how much you risk per trade, and how big a position to open.
Having a well-designed risk management strategy is what helps you protect your capital from unnecessary losses and from risking more than you should.
How to avoid getting a margin call?
The worse thing that could happen to a trader is getting a margin call. Not only it hurts his trading psychology but it also hurts his finances.
A margin call occurs when the value of your margin account falls below the broker’s required amount. The broker will ask you to deposit additional money so that the account is brought up to the minimum value.
This minimum value or margin is used as collateral that you have to deposit to insure against any losses that you may incur in your trading account. Your initial margin is what constitutes the rate at which you will receive a margin call to deposit more money in your trading account to cover losses.
The strategy here is to find the sweet spot between the maximum of the amount of exposure that you are allowed to take and the number that you deposit into the account.
For example, if you leverage your account x10 and you lose 10% of your capital, you get a margin call. If you leverage x5 and you lose 20%, you get a margin call.
Assume you deposit a $1,000 into your trading account with a 100:1 leverage. Your overall exposure that you are allowed to take is $100,000, if you lose 1% of your margin (which is the $1,000 deposit) you get a margin call.
Here’s how you can calculate your margin call percentage:
1/Leverage = % Margin call, with a 100:1 leverage your margin call percentage is 1/100 = 1%.
You can use this rate to adjust the stop loss of your entire portfolio so that you never get a margin call.
How much should you risk per trade?
The golden rule for risk management is to “risk no more than 2% of deposit per trade.”
The 2% rule is an effective management strategy where you risk no more than 2% of your initial margin on any single trade. To implement this rule, you must calculate what 2% of your available trading capital is. The maximum permissible risk is then divided by your stop-loss to determine your position size for that specific asset you are trading.
For example, if your initial deposit on margin is $1,000 then your 2% risk is $20 per trade. This simply means that for every trade you place, you are willing to risk no more than 2% ($20) of your capital.
This 2% risk management rule is what helps you stay within specific risk parameters to avoid getting a margin call.
For example, a trader who uses the 2% rule and has a $100,000 trading account, risks no more than $2,000–or 2% of the value of the account–on each trade. By knowing what percentage of investment capital may be risked, the trader can calculate the position size to risk no more than 2% limit.
The table below shows two traders with the same initial capital – $1,000. The difference is that the first trader risks 2% of his account per trade, while the second trader risks 10% of his account on each trade.
If each trader has 10 losing trades in a row, the first trader will have $833.79 left, while the second trader will remain with only $387.37.
This is why risking 2% of your entire deposit is the best strategy to increase your chances of making money and staying in the game.
|Trades||Account balance||2% Risk per Trade||Account balance||10% Risk per Trade|
How to calculate your position size?
Position sizing is a technique that determines how many units (or lots) you should trade to achieve the desired level of risk.
It’s very important to choose your position size wisely. Here’s the golden rule:
Position Size = Risk /(sell price – buy price)
Your risk has to be expressed in the quote currency.
For instance, if you trade EUR/USD the quote currency is USD and if you trade USD/JPY the quote currency is JPY.
Now assume that you have a $10,000 trading account and want to trade Forex. Using the 2% rule, you can risk $200 of your initial margin per trade ($10,000 x 2%). If your risk per trade is $200 and you want to go long AUD/USD:
- Entry Price: 0.6900
- Stop loss: 0.6200 (700 pips)
- Quote Currency: USD
- Risk 2%: $200
- Position Size: 2.9 Micro lots or 0.29 Standard lots
If you trade using 0.29 lots you will lose exactly $200 (2%).
Now, let’s see for short position on USD/JPY:
- Entry Price: 119.00
- Stop: 124.00 (500pips)
- Quote Currency: JPY
- Risk 2%: ($200*124.00) = 24,800 JPY
- Pip Value: (24,800/500) = 49.6 JPY
- Position Size: 4.96 Micro lots or 0.0496 Standard lots
How to determine your net exposure?
Net exposure is the difference between your long positions and your short positions.
For example, let’s assume you short USD/JPY with a profit of $1,500 and you short AUD/USD with a profit of $2,900.
This means that you sold USD in USD/JPY and bought USD in AUD/USD.
Your net exposure is: USD = $2,900 – $1,500 = $ 1,400.
How to manage and scale open positions?
Here’s how you manage and scale your open trades:
1. Move your stop loss, calculate the new price using this formula:
SL New Price = (SL Initial Price – TP Price)/2 In Sell Position
SL New Price = (TP Price – SL Initial Price)/2 In Buy Position
Then add/subtract it (buy/sell orders) from your Entry Price.
2. Increase your position size:
Calculate the average price of your position:
Average Price = (Entry Price + Target Price) /2
Your new Entry should be placed at the target price of your initial position.
For the SL of the increased position, use the same price of the SL you just moved.
How to deal with drawdowns?
By definition, a drawdown is the difference between a high point in your trading capital and your low point in your account balance. Let’s say that your account balance was $10,000 and you lost 10 trades in a row bringing your capital to $6,000, so your trading account has experienced a $4,000 drawdown.
Personally, I set my drawdown percentage to 20% of my entire capital. This means that I am allowed to open up to 10 trades with 2% risk each. If I lose 20% of my account, I take a break for the rest of the month.
Once you experience a drawdown, you need to reduce your risk by 25% from 2% to 1.5%.
You can increase your risk per trade from 1.5% to 2% only when you break even.
As a Forex trader, you must limit your leverage to 8-10X instead of using 100-500X. You only increase your leverage when your making money in your account. By increasing your leverage your risk is decreasing because you are making money.
Always compare your ATR% with your margin call percentage to adjust your portfolio stop loss percentage. To calculate your ATR%, read this article about ATR volatility.
Never risk more than 2% of your entire capital per trade. When you experience a drawdown, close down your whole portfolio and take a break from trading for the rest of the month. Stick to this process and never deviate from your trading plan and your risk management rules.