What follows might be the most important content you read this year on forex trading. This may sound exagerrated, but it isn't all that much when you consider that proper risk management is the most important aspect of a profitable forex trading strategy.
Risk management is the term given to describe the different ways to manage the risk-reward ratio of every trade you make. If you don't fully understand the implications of this, you have very little chance of becoming a consistently profitable forex trader.
Below, we will explain the most important aspects of managing risk: the risk-reward ratio, position sizing, and the fixed risk in pounds versus risk as a percentage.
The reward generated in exchange for your willingness to risk your capital is the most important aspect of managing risk. However, many traders don't fully understand how to take full advantage of the power of risk in relation to reward. Every trader in the market wants to maximise their reward and minimise their risk. This is the basic building block for becoming a consistently profitable trader. Understanding and properly implementing risk management provides a practical framework for you to achieve this.
Risk and reward doesn't just mean calculating the risk and reward of a trade, it means understanding that with a profit target 2-3 times the risk (or more) on all of your trades, you should be able to earn money on a series of trades even if you lose most of the time. When you combine the consistent execution of a risk/reward ratio of 1:2 or greater with a high probability trading advantage like price action trading, you have the recipe for a very powerful trading strategy.
Let's take a look at the 4-hour gold chart to see how you calculate the risk/reward on a pin bar pattern. You can see from the chart that there an obvious pin bar formed from the support in an uptrend market, so the price action signal was strong. Next, you calculate the risk; in this case the stop loss is placed just below the low of the pin bar, so you calculate how many lots you can take given the distance of the stop loss. We will assume a hypothetical risk of £100 for this example. You can see that this setup has so far yielded a reward of 3 times the risk, or £300.
Now, with a reward that's 3 times the risk, how many trades can you lose out of a streak of 25 and still generate a profit? The answer is 18 transactions, or 72%. You can lose 72% of your trades with a risk/reward ratio of 1:3 or more and still make money... on a series of trades.
Here's the quick math:
18 losing trades at £200 risk = - £3,600, 7 winning trades with a reward of 3R (risk) = £4,200. So after 25 trades you would have won £600, but you would also have had to endure 18 losing trades - and the problem is that you never know when the losers are going to happen. You could have 10 losers in a row before one winner appears; this is unlikely, but it's nevertheless possible.
So the risk/reward ratio basically boils down to this main point: you have to have the courage to place and forget your trades on a series of transactions large enough to realise the full power of the risk/reward ratio. Obviously, if you are using a high probability trading method, you are unlikely to lose 72% of the time. So imagine what you can do if you implement risk/reward correctly and consistently with an effective trading strategy.
Unfortunately, most traders are either too emotionally undisciplined to properly apply this risk/reward ratio or they don't know how to do it. Meddling in trades by moving stops further from the entry or not taking a logical 2 or 3R profit when they do arise are two big mistakes traders make. They also tend to take profits of 1R or less, which only means that you have to earn a much higher percentage of your trades to make money in the long run. Remember, trading is a marathon, not a sprint, and how you win the marathon is through the consistent implementation of the risk/reward combined with mastery of a truly effective trading strategy.
Position sizing is the term given to the process of adjusting the number of lots you need to meet your predetermined amount of risk/stop loss distance. This may be a bit hard for newbies to grasp, so let's break it down piece by piece.
Here's how to calculate your position size for each trade you make:
1) First, you need to decide how much money in pounds (or euros, or dollars) you are comfortable losing on each trade.
2) Find the most logical place to place your stop loss. If you are trading on bar pin setups, it will usually be just above/below the top/bottom of the bar bit. The basic idea is to place your stop loss at a level that will invalidate the setup if hit, or across an area of obvious support or resistance; this is the logical placement of the stop. What you should never do is place your stop too close to your entry just because you want to take a bigger lot size, that's greed, and it will likely backfire on you.
3) Next you need to enter the number of lots or mini lots that will give you the pound risk you want with the stop loss distance you have decided to make the most sense. A mini-lot is usually around £1 per point, so if your preset risk amount is £200 and your stop loss distance is 50 points, you can take 2 mini-lots; £4 per point x 50 stop loss points = £200 risk.
The above three steps describe how to properly use position sizing. The most important point to remember is that you never adjust your stop loss based on the size of your position; on the contrary, you always adjust the size of your position according to the predefined risk and the logical placement of your stop loss.
The other important aspect of position sizing that you need to understand is that it allows you to have the same amount of risk on every trade. For example, just because you need to have a larger stop on a trade doesn't mean you need to risk more money on it, and just because you might have a smaller stop on a trade doesn't mean you're going to risk less money on it. You adjust your position size to meet your predetermined risk amount, regardless of the size of your stop loss. Many newbie traders get confused and think they risk more with a larger stop or less with a smaller stop; this is not necessarily the case.
Let's take a look at a EUR/USD chart. We can see two different price action trading setups: a pin bar setup and an inside bar pattern. These setups require different stop loss distances, but as we can see from the chart below, we are still risking the exact same amount on both trades, thanks to position sizing:
Fixed risk in pounds model = you determine in advance how much you're willing to lose per trade and risk the same amount on each trade until you decide to change your risk.
Risk as a percentage model = you choose a percentage of your account to risk per trade (usually 1 or 2%) and stick to that risk percentage.
Although the %R method makes an account grow relatively quickly when a trader achieves a series of gains, it actually slows the growth of the account after a trader achieves a series of losses, and makes it very difficult to bring the account back to the level where it was before. This is because with the %R risk model you invest with fewer lots as the value of your account decreases. While this can be a good thing for limiting losses, it also puts you in a rut that is very difficult to get out of. What is needed is mastery of your trading strategy combined with a fixed pound risk that you are willing to lose on any given trade. When you combine these factors with consistent risk/reward execution, you have a great chance of making money on a series of trades.
The %R model essentially prompts a trader to "lose slowly" because what tends to happen is that traders start to think "since my position size decreases with each trade, there's no problem if I trade more often"... and even if they don't specifically mean that... this is what often happens. I personally think the %R model makes traders lazy... it makes them enter trades that they wouldn't have otherwise taken... because now that they risk less money per trade, they don't value their money as much... it's human nature.
In addition, the %R model is of no use in the real world of professional trading as account sizes are arbitrary, which means that the account size doesn't reflect each person's true risk profile, and also doesn't represent all of his net worth. The account size is actually a "margin account" and you only need to deposit enough into the account to cover the margin on the positions... so you could have the rest of your trading money in a savings account or in a mutual fund or even precious metals... many professional traders don't keep all of their potential risk capital in their trading account.
The fixed risk in pounds model makes sense for professional traders who want to earn real income from their trading. Professional traders actually withdraw their profits from their trading account each month, then their account returns to its "base" level.
Consider a hypothetical sample of 25 tradess. We'll compare the fixed pound risk model to a 2% risk model. Note: We have chosen the 2% risk because it is a very popular risk percentage among newbie traders. The fixed pound risk was set at £200 per trade in this example, just to show how a trader who is confident in his skills and trades like a sniper would be able to build his account faster than someone else who is satisfied with a 2% risk per transaction. In reality, the fixed risk in pound varies from trader to trader and it is up to the trader to determine what he is really prepared to lose per trade. For me, with a small account of £4,000, I would personally be comfortable with a risk of about £200 per trade, and this is reflected in the next example.
Following an analysis of this series of random trades, it appears that the fixed pound model is superior. Of course, your account will shrink a bit faster when you encounter a streak of losing trades with the fixed pound risk model, but the flip side is that you'll also build your account much faster when you encounter a streak of winning trades (and you recoup losses much faster). The key is to trade like a sniper and master your trading strategy - you'll be unlikely to have a lot of consecutive losing trades, so the fixed pound risk model will be better for you.
In the below example, we'll look at the fixed pound risk model versus the percent risk model:
Outcome for a risk of £200 per transaction = +£1,400
Outcome for a 2% risk per trade = +£524
This example is a bit extreme. If you use price action trading strategies and really master them, you shouldn't be losing 68% of your trades! Your losing rate should be closer to 50%. You can imagine how much better the results would be with a 50% payout percentage. If you win 50% of the time on 25 trades by risking £200 on a £4,000 account, you will have £9,000. If you won 50% of the time on 25 trades by risking 2% of £4,000, you would only have about £6,600.
Many professional traders use the fixed pound risk method because they know they have mastered their trading strategy, are not over-trading, and are not relying on excessive leverage, so they can safely risk a set amount that they are willing to lose on each trade.
People who use the %R model are more likely to overtrade and think that because their risk in pounds per trade decreases with each loss, it's ok to increase the number of trades (and therefore lose more trades because they are taking low probability trades)... but over time, the overtrading puts them much further behind a trader who uses a fixed risk in pounds who is probably more cautious and acts more like a sniper.
To increase your odds of making moolah in the financial markets, you not only need to have a thorough understanding of the risk-reward ratio, position sizing and the amount of risk per trade, but you also need to consistently execute each of these aspects of risk management in combination with a very effective yet simple to understand trading strategy, such as price action.