With forex trading, the thrill of the chase when executing a series of trades can be intoxicating. However, it is important not to lose your shirt in the process. Even the best traders can go on multi-trade losing streaks that can last for weeks, only to recover later.
If the same trader is using too much of their trading capital with each trade, they can be wiped out. This is where good risk management policies come into play to ensure that they can stay in the (trading) game long enough for future trades to recover earlier trading losses.
Guest post by Martin Brooke of Simple Forex Money
Reward to Risk Ratio
When deciding on what trades to make, consider what the potential upside (reward) you believe is possible with the successful completion of a transaction.
In order to factor this in, you need to think about the spread (the difference between the buy and sell price which includes the market maker fee for the trade). The spread is a completely different cost to a Forex brokers’ fee.
To cover the costs, you need the reward from the trade to have large enough pips to more than cover the fees. In addition, you will put a stop in place to execute a sell order automatically should the trade move against you. This protects your capital.
If the spread is 2 pips and a 50 pip trading loss is acceptable on the downside, then you may want to aim for a trade with a potential reward of 152 pips in order to get a good 3:1 Reward–Risk ratio. This means, a downside of 50 pips, with an upside of 152 pips to cover the spread, and achieve a 3:1 (150:50) Reward-Risk ratio.
The best way to achieve a comfortable ratio that allows for market fluctuations in the very short term, is to place less capital at risk with each trade. This way, it is possible to ride the market and not get stopped out (forcing a sale) if the market takes an unexpected short-term downward move shortly after the initial trade is executed. A larger reward-risk ratio is then possible because you can tolerate more fluctuations (or losses) because less capital is tied-up in the trade.
Capital Protection & Risk Management
It is recommended that each trade use no more than 2% of investable capital. This ensures that a serious of bad trades do not wipe out the capital base.
Risk management is about ensuring you do not go broke. By keeping each trade to just 2% of capital, an account would need to lose 50 times (excluding broke execution fees) to lose everything. An even more cautious approach is to take 2% of the remaining capital and trade that. This reduces the capital sum deployed for each trade, but ensures that an account would never run down to zero.
Further reading: Top 10 Scary Facts About Placing StopsGet the 5 most predictable currency pairs