Now that we have learned how to analyze the chart, open and manage orders, we need to scale the position and define the correct amount of lots to buy or sell. Risk management is the trader's most important task.
Now, before we can get our math on, we need five pieces of information:
- Account equity or balance
- Currency pair you are trading
- The percent of your account you wish to risk
- Stop loss in pips
- Conversion currency pair exchange rates
To facilitate understanding, let's take an example. A trader starts his trading account with $ 10,000 and would like to open a trade on EURUSD by risking a maximum of 200 pips. As a risk management strategy, he defined that he does not want to lose more than 2% in this operation. For this to happen, he must calculate the size of his position to stay within his risky comfort zone.
The maximum loss of 2%, using your account balance, represents a $ 200 risk as calculated below.
$ 10,000 x 2% = $ 200
To find the pip value, we divide the risky amount by the stop.
($ 200) / (200 pips) = $ 1 / pip
Finally, we multiply the value of the pip by a value ratio of each pair. In this case EURUSD, that 1 lot for each pip move is worth $ 10.
1 US$pipx 1 (lot of EURUSD)10 (US$pip)=0,1 (lot)
Therefore, this trader must place an order of 0.1 lot of EURUSD to remain within his risk comfort level with his current trading setup.
Knowing how to set the right position sizes is a crucial part of becoming a risk management professional. Stick to your predetermined stops and risk comfort levels and you will be sure to have enough after your losses to take advantage of future profitable opportunities.
Managing and preserving trade capital is the trader's most important job. The truth is, there is no way to know what the next market movement will be. Trades are based on probability and market analysis.
Every day is a new challenge, and almost everything, from global politics, major economic events, to rumors from the central bank can turn currency prices up one way or another faster than you can react. This means that it will eventually take a position on the wrong side of a market movement. Being in a losing position is inevitable, so risk management is essential to succeed in this endeavor.
Having a predetermined point of exit from an operation not only provides the benefit of cutting losses so you can move on to new opportunities, but it also eliminates the anxiety caused by being in a lost operation without a plan. This point is called Stop Loss.
The main purpose of a stop loss is to limit losses. Each trade has only two possible outcomes. Profit or loss. Now imagine that Trader A's strategy is not in a good phase and the sequence of results is 10 losses in a row. If the maximum risk per transaction is 10%, he just blew up his account. However, Trader A has limited his maximum trading loss to 1%. He would have an accumulated loss in this pessimistic scenario of 10%, keeping 90% of the capital insured.
Now that we know the importance of risk management, we need to know how to define a Stop Loss.
There are several ways to define the stop location. Let's start with the most basic type: the percentage-based stop loss. The percentage-based stop uses a predetermined portion of the trader's account. For example, 3% of the account is what a trader is willing to risk in a trade.
Once the percentage risk is determined, the Forex trader uses the size of his position to calculate how far he should set his stop from his entry. However, we will see that this positioning strategy is not the most recommended, as you should always set your stop according to the market environment or the rules of your system, not based on how much you want to lose.
Although it looks confusing, it is not. Let's take another example:
Trader B has an account with US $ 1,000 and according to his entry strategy, he decides to open a sale just below the EURUSD resistance at 1,18980. According to your risk management rules, you will not risk more than 2% of your account per transaction. Therefore the risk in pips with 0.1 lot would be 20 pips.
Let's see what happens next.
But as he defined the stop based only on the risk percentage of the account and not the market movement, his stop loss was very short. And in addition to leaving the trade very early, he missed the chance to win many pips.
From this example, you can see that the danger of using percentage stops is that it forces the Forex trader to set his stop at an arbitrary price level. This stop will either be located very close to the entrance or at a price level that does not take technical analysis into account.
The most appropriate strategy for order management is to find a suitable location for the Stop Loss position based on the support and resistance of the charts, and then calculate the position size based on the account percentage.
Let's take another example, the graph below shows the breaking of a resistance. Trader C decides to open a buy at this break, and according to his graphical analysis, determines that the best stop position would be just below the last downward swing at 1.26600.
Now to effect the new trade, he needs to define the position size. This trader has $ 10,000 in his trading account and wants to risk 5% of his capital in this operation. We know that the stop will be at 1.26600 and the entry was at 1.27600. So a stop of 100 pips.
The number of lots for this operation will be calculated as follows:
500 (US$)100 pips risk x 10 (US$pip)=0,5 (lot)
So the trader will open a 0.5 lot buy with a stop at 1.2660. With the risk limited to 5% of your trading account, let's see what happened next:
That's a good trade!
Risk management is one of the most important elements for the success of the trader. If you continually practice the correct way to set stops, record, and review your thought processes and trading results in your journal, you are one step closer to becoming a professional risk manager.