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What is Risk Management in Forex Trading?
Risk management in forex trading is one of the most important topics in the field of finance. Forex being a vital part of financial management has also a part of risk management in it. Foreign exchange is the business of making money from investing money like any other investment. But it is a matter of great regret that this topic is one of the most overlooked one. Most of the traders who enter into this business are just over curious in eking out profit but they seem to have no concern for their total account size. This is one of the main reasons why most of the traders who enter into the fray of forex fail miserably. This kind of earning without learning is always suicidal and nothing less than gambling.
Let us provide you with an example. A lot of people go to casinos to win a jackpot. And a huge number of them actually end up winning one but that does not mean that they are very good at gambling. On the other hand, the management of casinos are also very smart people. They are able to run their gambling business in a very profitable way in the long run because they rake in more money from those people who don’t win jackpots. This is exactly where the saying, “the house always wins” comes from.
In order to remain in the casino business, their management employs statisticians. They know very well that they will be the ones who will be making money. Even if someone wins a jackpot worth $100,000 in a slot machine, the casino management knows very well that there will be hundreds or thousands of gamblers who will end up losing their money, making the casino profitable.
Forex exchange market is no different when it comes to winning or losing money. The only difference is here in the foreign exchange business there are a number of tools that as an investor you can employ to make your chances of winning better. But this is not the case of gambling. There is no such thing called risk management in gambling but forex is different. In this platform of InvestoPower, we promote the concept of earning after learning. This learning thing will make life easy for you, and will equip you with the ability to identify many more opportunities as they present themselves. Sound knowledge of the workings of this market along with a commitment to prudent risk management will make you go a long way in this business.
Amount of Trading Capital Needed for Forex Trading
This is the first step in risk management in forex trading. There is a very old and time proven saying in the circles of finance and that is, “never ever put all your eggs in the same basket”. The underlying wisdom of it is that, if you suddenly fall into the road then you may end up dropping that basket and that may result in the destruction of all those eggs. Instead of placing all those eggs in the same basket, had you placed those in different places then chances were there that you would have been able to save the majority of them.
This is the first lesson that you should keep in mind. You should only be investing that much money in the forex business whose loss you can tolerate. If you have $100 bucks in your pocket and if it’s all you have then don’t go investing. If you lose that amount then you will be dead broke. So only invest that much money which you can afford to lose.
Here the million dollar question is, how much money you should invest. There is a hard and fast answer to this question. If you practice proper risk management then you can probably start with $5 to $10 thousand dollars as trading capital. It is very common to see that most of the businesses are failing due to undercapitalization, this is also evident in the foreign exchange market. If you do not have that much money to start your forex business then do not be impatient, wait, start saving money then jump into the fray.
Drawdown and Maximum Drawdown
First of all, any investment is a longer term phenomenon. If you are thinking that investing in the forex market will make you rich overnight then you are wrong. Yes, there are people who are becoming very rich faster than other people in the foreign exchange market but that is not the norm, that’s the exception. You have to think in the long-term perspective. Here, we will be discussing the concepts of “drawdown” and “maximum drawdown”.
A drawdown is the gradual reduction of one’s capital after undergoing a series of financial losses in the trades. This is often measured by getting the difference between a relative peak in capital minus a relative trough. Traders usually calculate it as a percentage of their respective trading account. For example, if you have $100,000 in your trading account and you ended up losing $25,000 then what percentage of money you have lost. The answer is 25%.
The graph shows peak, drawdown, and trough
Here, you can form a good plan. But remember, it does not matter how effective and robust your planning is, you will always make some losses. No trader always comes out successful. In the case of forex, all you need to do is to look for an edge. That is the main reason traders develop systems. For instance, if your trading system is 80% profitable that does not mean that out of every 100 trades you take, you will be losing only 20 times and winning the rest of the time.
You can lose 20 trades in a row and start winning the remaining 80 trades, but here the question is whether you will still be in this business if you incur losses consecutively? This is why the concept of risk management is very crucial. The key to success in this situation is that you will have come up with a specific trading plan that will enable you to withstand these periods of huge losses. And part of your game plan should be having an effective risk management mechanism in place.
Golden Rule of Risk Management in Forex Trading
Financial analysts say that you should never risk more than 2% per trade. As a newcomer, it may seem very high to you but we will help you get a glimpse about the difference between risking a small percentage of capital to risking a higher percentage of capital. A table is given below to make things clear.
Risking 2% vs. 10% Per Trade
| Trade | Total Account | 2% Risk Per Trade | Trade | Total Account | 10% Risk Per Trade |
|---|---|---|---|---|---|
| 1 | $20,000 | $400 | 1 | $20,000 | $2,000 |
| 2 | $19,600 | $392 | 2 | $18,000 | $1,800 |
| 3 | $19,208 | $384 | 3 | $16,200 | $1,620 |
| 4 | $18,824 | $376 | 4 | $14,580 | $1,458 |
| 5 | $18,447 | $369 | 5 | $13,122 | $1,312 |
| 6 | $18,078 | $362 | 6 | $11,810 | $1,181 |
| 7 | $17,717 | $354 | 7 | $10,629 | $1,063 |
| 8 | $17,363 | $347 | 8 | $9,566 | $957 |
| 9 | $17,015 | $340 | 9 | $8,609 | $861 |
| 10 | $16,675 | $333 | 10 | $7,748 | $775 |
| 11 | $16,341 | $327 | 11 | $6,974 | $697 |
| 12 | $16,015 | $320 | 12 | $6,276 | $628 |
| 13 | $15,694 | $314 | 13 | $5,649 | $565 |
| 14 | $15,380 | $308 | 14 | $5,084 | $508 |
| 15 | $15,073 | $301 | 15 | $4,575 | $458 |
| 16 | $14,771 | $295 | 16 | $4,118 | $412 |
| 17 | $14,476 | $290 | 17 | $3,706 | $371 |
| 18 | $14,186 | $284 | 18 | $3,335 | $334 |
| 19 | $13,903 | $278 | 19 | $3,002 | $300 |
From the above table, it is clearly visible the difference between risking 2% of your trading account and risking 10% of your account on a single trade. If you are into a losing spree and lose 19 different trades consecutively then you would have gone from starting with $20,000 as initial capital then you will have only $3,002 left in your account if you decide to risk 10% on each trade you undertake.
Here is the table presented to clarify about what percentage you would have to make to break even if you were to lose a certain percentage of your trading account.
| Loss of Capital | % Required to Get Back to Breakeven |
|---|---|
| 10% | 11% |
| 20% | 25% |
| 30% | 43% |
| 40% | 67% |
| 50% | 100% |
| 60% | 150% |
| 70% | 233% |
| 80% | 400% |
| 90% | 900% |
As evident from the above table, the more you lose in forex trading, the harder it will be for you to make it back to your initial account size. We think you realize the gravity of the situation and should do whatever it takes to protect your trading account.
Reward-to-Risk Ratio in Forex Trading
If you want to be profitable in the long run then you will have to adopt a specific strategy and that is, as some experts say, you will have to make sure that you have the potential to make 3 times more than you are risking in trading. And that is a 2:1 reward-to- risk ratio. If you follow this formula then we can assure you that you will have a significantly higher chance of ending up profitable in the long run. Below is a table given that will present a hypothetical example to make the point more clear.
| 10 Trades | Loss | Win |
|---|---|---|
| 1 | $1,000 | |
| 2 | $2,000 | |
| 3 | $1,000 | |
| 4 | $2,000 | |
| 5 | $1,000 | |
| 6 | $2,000 | |
| 7 | $1,000 | |
| 8 | $2,000 | |
| 9 | $1,000 | |
| 10 | $2,000 | |
| Total | $5,000 | $10,000 |
In the above table you can see that even if you end up winning 50% of trades taken, you would still end up with a fortune of $5,000. Here, the important point is whenever you start trading with a good risk to reward ratio, your chances of being profitable will be much higher even if you end up having a much lower winning percentage.
If you are forced to downsize your position, then you can go for widening your stop to maintain your desired reward to risk ratio. Do not take that much stress on this and keep in mind that, in the real world, the risk-to-reward ratios are not inscribed on stone. They can be adjusted depending on time frame sought, trading environment, and both the entry and the exit points.
Study Your Losses to Make Things Clear
Everyone wants to win, no one wants to lose. But losses are part of real life trading scenarios. What we are suggesting here is that as a trader it is not wise to remain fixated on the instances of win. Rather you should actively study your losses too. As the saying goes, failure is the pillar of success. Trading is no different. If you go to study the intricacies of your losses then you will learn things that will enrich your knowledge and remain profitable in the longer run. Here are three ways of analyzing your losing trades.
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Calculate Your Performance
For calculating your performance you will have to collect past data on your profits and losses. After collection, you will have to calculate your average gain. Then find your average loss and then calculate Profit and Loss Ratio which is Average Gain/Average Loss.
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Drill Down on Your Losses
Paying extra attention to your past mistakes as a trader will help you go a long smooth way into the world of forex. Even if you follow a sound risk management plan and do your homework adequately, a taken position can move against you within a fraction of a second right in front of your eyes. How you handle those kinds of situations will make the ultimate difference on your being either a successful or a failed trader. A right way to approach your past mistakes is to contemplate on “how long” and “why” you allowed a taken position to fall before you decided to act.
Sometimes, some of our bad habits are casting a deep shadow on our decision making ability. By approaching the issue in this way you will be able to identify the habit so that you can take corrective measures. A most likely finding might be that you are just allowing the losing trades to go on for too long. If this is the case, then you will need to cut the time. The learning here is that, you should try to come out of a losing trade before it reaches your average loss. In this way, you will see some drastic improvements in your performance.
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Calculate Your Trade Expectation
Expectation or trade expectancy is defined as the average amount you are expecting to make or lose per trade based on your past record. It combines the percentage of profitable trades and average gain per trade with the percentage of lost trades and average loss per trade.
Analyzing your past record on a regular interval can help you better understand the behaviors and other factors that may be influencing your trading results. Paying close attention to losses is a great way to identify any shortcomings.
