This article discusses the element of risk in trading, money management and what strategies are available to tackle trading risks.
For the purpose of this article, risk is defined as any event that causes a loss of capital in trading. These events are usually actions that result in trade losses, whether those losses have been realized (on closed trades) or unrealized (trades that are still active). There are several risk factors for trades. These are all discussed below, as well as how to mitigate them.
- Maximum Drawdown
The maximum drawdown is defined as the drawdown that causes the highest percentage loss of equity among several drawdown peaks. The maximum drawdown is used to estimate what the worst possible risk effect would be on an account. It is essential to know what the maximum drawdown in a trade would be so as to design a system of money management that would protect the account and give it the ability to withstand the shock that could result from the maximum drawdown.
- Risk in Relation to Reward
Another element that poses a risk to the account is the level of risk used in chasing a reward; the reward to risk ratio. A popular method of calculating this is by using the profit/loss ratio, or the profit factor. In simple language, the ratio of the profit target in relation to the stop loss is what is meant by the profit/loss ratio.
Whatever method is used for this calculation, a reward to risk ratio of at least 3:1 is the most desirable. This means that in determining a good TP:SL ratio, a trader should aim for a minimum of 3 pips in Take Profit for every pip set as Stop Loss. Some traders may tolerate a ratio of 2:1. In choosing trades that can mirror this reward-risk ratio, choose trades where risk is limited and the reward is unlimited.
- Initial Capital
This is one factor that traders never consider as being a risk element, when indeed it is. The initial capital determines how much reserve capacity an account has, which gives it the ability to withstand a series of adverse trade outcomes. Picture this scenario: would you rather travel a distance of 1000 km with a 50-litre capacity vehicle or a 70-litre capacity vehicle, especially if there is a limited number of refueling points along the journey? The answer is obvious. This is the same with initial capital in forex. The risk of incurring losses right from the beginning of a trading journey as is the case with many beginners. This can only be offset if the initial capital is sufficient to create a buffer for more trades to be done in an attempt to establish account recovery. Individual losses are not usually the issue, as stops can be deployed to control what is lost per trade. The problem arises when there are multiple losses that make the loss of capital a real danger. A run of losses weakens the ability of the account to take on new trades, both in number and magnitude.
As a rule, it is important for the initial capital to possess a minimum of three times the required margin for each traded contract, or at least twice the amount of the maximum drawdown + initial margin. The Monte Carlo simulation system can be used to derive a more precise number by using historical simulations to estimate at what point a complete system failure would occur. The levels derived from such tests must have a cushioning factor of at least double or triple the estimation to cater to surprises that could occur in the market.
The forex market is highly leveraged. Leverage is the action of taking a loan from the broker to bolster trading positions for the purpose of increasing what could potentially be gained from a trade. Leverage is a two-edged sword, because if a loss is incurred, then the loss is magnified as well. What makes leverage particular relevant as a risk factor is that it magnifies other risk factors for a trade. How can you mitigate the risk factor in leverage?
One way is to reduce it. In the US, regulators have already done that, cutting the maximum allowable leverage to 50:1. You can do this on your own account too. This means you use less of borrowed funds, and more of your own money (which still comes to having adequate initial capital). This naturally forces the trader into holding position sizes that are more agreeable with money management practices.
The second method is to only take a leverage when a risk-free investment portfolio is added to the leveraged one, and adjusting the investment basket according to the maximum drawdown the trader is willing to allow.
For example, sound government bonds are essentially risk-free investments; a return is always reaped. If the models indicate that maximum drawdown could be up to 50%, but the trader can only accept 25%, the trader can buy into government bonds with half of the capital available, and put the other half into forex, which reduces the max drawdown by a factor of half (25/50 = half).
If the models calculate the max drawdown and it comes to 15%, but you are willing to take more risk by allowing a drawdown max of 30%, you can then leverage your portfolio by taking on a leverage that doubles the portfolio’s risk (15 X 2 =30), but which also has the potential to double the return as an added benefit.
- Position Size
Position size also poses a major risk to a forex trade, and also represents a point at which money management interventions can be mounted to mitigate the risk to a forex account. Committing too much of account capital into a single trade or multiple trades can negatively impact on an account, especially if a series of losses is incurred. Position size is a direct component of risk. It is important to determine the minimum account capital required to trade a particular system or strategy profitably.
Position size should be a percentage of capital that aligns with money management principles. This percentage of capital can be calculated using this formula:
% of capital = ([(A + l ) x p ] – 1 ) /A
- A is the average payoff ratio (or profit ratio)
- p is the percentage of wins
If the % of wins (p) = 7.8.7%
- Average win trade amount – $2500.00
- Average loss trade amount – $25.40
Average payoff ratio = 98.43
So the optimal % of capital to use in the trade = ([(A + 1)x pi – 1 )M
= (1(98.43 + 1) x .078) – 1) /98.43
This means that investing more than 6.86% of the account capital into trades will put the account at risk of being blown by losses.
- Psychological Risk
Trading is a highly emotional and psychological event. Many losses are due to irrational actions on the part of traders. There are factors that also put traders in a poor emotional state: sleep deprivation, anger, external discomforting influences, bad news, etc, can all affect a trader’s mental state negatively.
A sequence of losses can also produce emotional imbalance, which also enhances the trader’s irrationality in making decisions. This is a vicious cycle. Traders who are unable to control their emotions are better off using automated systems in trading.
- Open Too Many Trades
Some traders open many positions on different currency pairs. If you lose money on several trades in several currency pairs, it is the same as losing money on several trades in one single currency pair. Ten losing trades in different markets is the same as ten consecutive losses in one market. Limit your number of open trades and save your margin from undue exposure.
- Poor Exit Strategies
The exit strategy is the end-point of the management of any trade. All strategies that has been discussed above are entry-related. This is the only one related to exit. Exit strategies are used to either capture unrealized profits, or to limit or even prevent capital loss. Exits are usually executed with a Take Profit (profit), with a Trailing Stop (profit) or with a Protective Stop (loss).
Exit stops should neither be too loose, or too tight. Too loose, and a larger loss than is necessary is incurred. Too tight, and choppiness of market noise can trigger it, resulting in lesser profit (Trailing Stop) or an unnecessary loss (a tight stop loss).
So what kinds of stops are deployed in executing market exit?
a) Protective stop (also known as stop loss)
This is used to protect against losses. Once set, it must be rendered inviolable (must not be shifted around). Methods of setting a stop loss include:
- Using a hard money stop, where the trader decides how much he is willing to set as risk to a trade. E.g., if a trader has a mini-lot position open in forex and is willing to risk $50, then the stop will be set at 50 pips.
- Using a technical stop, which is a situation where a technical basis is used to determine where to set the stop. E.g., a trader who wants to go long on the EURUSD will have to determine the support area for the currency pair, and set the stop loss below that support so it does not get triggered by market noise.
Both methods require other considerations to be made as well.
b) Trailing Stop
This is a profit protection stop, used to safeguard profits already collected (but unrealized) against adverse market movements. Again, this must not be too tight as to choke a trade that has potential to do better than it already has, and also must not be too loose as to give up too much to the market if the market starts to retreat against the position.
A trailing stop is only placed when the trade has attained a certain level of gain. This is usually the breakeven level. At this point, the stop is applied to the entry price in such a manner that market noise does not trigger it, leaving the trade with a chance to advance and do better.
Also Read: STOPS in Forex Trading
Some traders would close half the position in profit, then move the stop loss to the entry price so that some measure of gain is attained. This method is in the writer’s opinion, the preferred option because it locks in some profit, allows a trade with further profit potential to remain open, and can NEVER lead to loss.
So only use the right kind of stops for your trade exits, and use them properly.