In this article I explain why risk management is important, how it can be measured, and how better risk management can be implemented quite easily using a few trading and accounting tools and tricks. If you follow my words, you will likely find this increases your overall profitability by more than searching for a “holy grail” trading strategy ever will.
hedged away broader stock market risk with his put option on the S&P 500 index. A similar (but more expensive) hedge would be to sell an appropriate quantity of futures or ETFs on the S&P 500 index.
Trader C is in a worse situation still. He bought XYZ and bought a put on the S&P 500 index. However, he did not hedge his currency risk – euros are his base currency. By buying a US stock denominated in USD, he is implicitly short EUR/USD. So, if his stock trade works, but at the same time the US dollar declines, he will not have the profit he expects because the currency movement will have eaten away at his profit.
Here are a few kinds of risk that your portfolio or trade may be subject to:
1. Market Risk: the risk that the market will perform differently to how you expect. This is the most common risk in trading.
2. Counterparty Risk: the risk that your broker will default or fail to return your funds (this is a real risk, and that is why it is best to use notional funding).
3. Liquidity Risk: the risk that you will not be able to open or close trades when you desire.
4. Model Risk: the risk that your trading model or your analysis model fails to accurately represent reality and will lead you into a series of trades or decisions that lead to losses.
5. Technological Risk: the risk that your computer, internet access, or anything IT-related will fail. For example, what if your broker’s platform fails to respond and you continue clicking, only to find out it was a lag and you opened 5 positions in the same direction?
6. Risk of Ruin: the risk of blowing up your account.
Avoid the Need to Be Right
Another component of Forex risk management has to do with the emotional need to be right. Aspiring traders typically try to devise ways to avoid losses and/or recover drawdowns immediately. Usually, this is expressed by an attempt to implement a martingale position sizing algorithm (i.e., doubling the risk on the next trade after each loss). The belief is that “the more losses in a row I get, the more likely it is that the next trade will be a winner”. Notwithstanding the fact that this is a fundamentally flawed understanding of probability in Forex trading, the following questions also need to be asked of this approach:
1. Even if you had infinite capital, at best you would break even by this approach. Do you have infinite capital?
2. If you double down and do not win, how many consecutive losses can you take before being wiped out? What is your risk of ruin?
3. Doubling down means throwing good money after bad money, the opposite of cutting losses.
These reasons are why a traders’ focus must be first on limiting risk and managing risk well, not taking on more risk to recover from losses. It is too easy to think about the potential gains that are possible trading the markets, without paying equal attention to the exponentially challenging battle that awaits if you let your losses get out of control.
Another issue is that the more you lose, the greater the percentage gain required to make up your loss and get back to even. Once you lose more than 20% of your equity, the gain required begins to really increase exponentially, as shown by the diagram below.
Gain Required to Recover from Loss
If you lose 20% of your account, it takes a 25% gain to break even. If you lose 50% of your account, it takes a 100% gain to break even. If you lose 70% of your account, it takes a 233% gain to break even. If you lose 90% of your account, it takes a 900% gain to break even.
There is only one solution: ensuring that your average profit is larger than your average loss. If your average win is twice as big as your average loss, you only need to be right 33% of the time. This is the math you need to drill into your head.
Relationship Between Reward to Risk and Win Rate
This implies the use of a stop loss which keeps losses small compared to potential gains. This also implies cutting losses. But also, without actually experiencing the large gains, traders will never break the vicious cycle of needing to be right. So, you also need to let your winners run.
How to Calculate Risk Management in Forex
Now we get into the nitty-gritty of Forex risk management practices. There are several steps to building a proper risk profile and establishing clear risk limits. At the end of the day, this exercise connects:
• capitalization
• risk limits
• position sizing
• win rate
alongside sound objectives and common sense.
Step 1: Astute Personal Financial Management
Starting from the top, the capital you allocate to your trading account should be money you can afford to lose. Your savings account is NOT your risk capital. Your risk capital for trading should be weighted within the overall picture….
Read More: Forex Risk Management Techniques and Strategies