Risk Management

From Volatility.RED

Risk Management happens when a trader takes active steps to minimize the potential of losing more money on a trade than they intended. It is a method unique to each individual trader that is meant to preserve capital so that they do not lose whatever they deem as too much money.

Risk management takes many forms and in this Wikki we will take a look at several ideas that may help you better understand this concept.

Note: Although we refer to Forex in much of this Wiki the concepts of Risk Management apply to all other areas of financial trading including equities, futures, options or even crypto.

This Wiki is a part of our Essential Forex Trading Guide. Be sure to check that out HERE.

Introduction to Risk Management

If a trader is lacking in sound risk management skills then all the other elements of professional Forex trading will become worthless because everything else you do in trading will collapse in on itself. Without managing risk professionally the risk of blowing out your account becomes way too high. The old saying “live to trade another day” comes to mind but we would rather say "protect your capital to trade another day". You need money to trade and if you are taking too much risk then you might run out of capital. No one wants to run out of capital because it sidelines your career as a trader.

Risk Management Example

The sad statistic that often gets taught across trading floors is that if 100 traders are given a $10,000 account and the exact same trading strategy, and that strategy had a 60% win rate that also won more pips than it lost on average, only 5 traders would still have $10,000 or more after 6 months! 95% would have lost pretty much everything, 3% would be about break even, and only 2% would have actually made a profit.

Think about this for a minute. In spite of having a 60% win rate that wins more pips than it loses on average, 95% of traders will potentially lose money on that strategy. That means that only 5% of traders will be at least break even and become successful Forex traders. One of the main reasons for this is poor risk management skills! Even though people are given a risk management system to go along with the 60% win rate they will inevitably change it for various reasons. Most of it comes back to poor Trading psychology which in turn made the trader change the risk management of a winning strategy.

The Wrong Approach

One major reason that traders lack sound risk management is because of how they approach the market. Most people come to the market hoping to change their financial situation because they are either unhappy with what they are currently doing or they want to make more money. For most retail traders they want to make more money because they don’t have much of it which puts a very real psychological burden on the trader to make money quickly. This can cause them to take unnecessary risk or try and cut corners to shorten the amount of time it takes to become successful. The reality is that it takes as much time in trading to become truly successful, just as it does in any other endeavour. You need to be prepared to gain this time and experience if you don’t want to become one of those negative statistics.

The Importance of Risk Management

Risk management is one of the most significant parts of any successful trading system. In fact, almost all new retail traders do not realize just how important it is. Risk management is not some sort of instinctive ability handed out to individuals when they are born. Rather, it’s a choice and a choice that we can all make when building our trading plan and trading business.

The purpose of this Wiki is to establish a framework on how you can build your own risk management strategy. This education will build the foundation from which you will build your entire trading business plan.

Right at the beginning of your plan, we need to focus on what your goal is as a trader. Your goal is to create your very own business and that business is trading the financial markets for a profit as a world-class speculator. Your goal is to become one of the 5% that win.

The money you make may come from numerous sources such as trading your own capital, managing the money of others who have more than you currently do, trading a prop account, selling your trading signals, or consulting in some context. The driving goal of your business is to be able to profit consistently from your trades in the Forex market.

The Realities of having a Trading Business

Before we talk about the realities of having a trading business we want to point out the 2 types of goals that you will need to focus on in order to think of trading as a business rather than something you just do as a hobby.

The 2 types of goals are outcome goals and process goals:

  1. Outcome goals focus on the end results such as how much money you will make or the number of pips you make.
  2. Process goals are specifics such as behaviours, feelings, or processes required to achieve the desired outcome.

A good way to describe this is by referring to the outcome goals as a jigsaw puzzle and the process goal as the pieces of that puzzle. Only by putting the process pieces of the puzzle in their proper place do you complete the outcome goal. Both are very important but the key is knowing when to focus on outcome goals and when to switch to process goals.

Generally speaking, the time to think about outcome goals is in the run-up to or after the trading performance. The time to think about process goals is immediately before and during the trading performance.

Just like any plan, once you have clearly defined what your desired outcome is and the reason why you want it, the next logical question is; how will you go about getting it?

Your process goals will be elements such as what you want to be doing and being. Doing will include areas such as preparation, how you are picking an entry, how you manage trades, how you exit trades, and how you are evaluating trades. Being goals include feelings and thoughts that are important to have. Most of your process goals should be 100% under your own control.

There are 3 main areas of your trading business that will need to focus on.

1. The incomes that trading will provide:

The starting point will be to determine what you need in order to satisfy your basic standard of living. This is just like in any business you should take out as little money as possible in the beginning so that you can afford to grow the business. This will most likely be in the form of your minimum salary.

Once you have identified the amount of money you need to live you can then turn it into a target goal that you can focus on. This can be daily, weekly, or monthly targets. This target goal will give you a process goal to focus on a trade by trade basis.

2. Your fixed cost of doing business:

These can include your seat fee if you are at a prop firm or the costs of computer equipment and internet. If you go the route of working with a prop firm they might charge you a seat fee to lease a trading desk on their trading floor. We can think of this as the rent you have to pay in a traditional business. Once you have these costs you can then factor this into your targets and process goals.

For example, if you need to make $2,000 per month to feed and shelter yourself and you have a fixed seat fee of $500/m and $200/m in various other expenses then you actually need to make $2,700 per month just to meet your basic needs. This equation does not take into account if you are managing client funds through a company which means that you will only get to keep a certain percentage of any of the profits you make. We are also leaving out income and business taxes which you will need to factor in as well.

For a lot of people managing money is the best route to go because they personally lack the necessary capital to sustain themselves. Once you start putting together a nice track record of at least 3-6 months on a small account you will have an easier time attracting investors to invest in your trading.

3. The variable costs of your trading:

These include items such as your brokerage fees, commission fees for trading, and any third-party services you use such as an audio news squawk and news feed, etc. Your trading losses can also be factored into this because you will inevitably have many losses over your career.

As a trader, you need to be focusing on these costs because you have control over them. For example, you can minimize your losses by operating in your best emotional state or you can reduce the amount of leverage you are using on each trade and focus on managing your trades better. We have a Wiki on your ideal trading state Here.

Once you have figured out all of these items you are then ready to start building your trading strategy, develop your trading mentality, and integrate your personal money management rules. The most important thing to bear in mind here is that your risk management skills will be a key aspect of your trading which in turn will determine whether or not you will achieve your goals and targets.

Risk Management Plan

In the following Wiki on Risk Management Plan we will explore concepts such as:

You can access the main Wiki on Risk Management Plan HERE.

Trading Unleveraged

One way to determine how much leverage you are using is by comparing the lot size of your trade to that of your account value. The simplest way of understanding how leverage works is by starting with how much money you have in your account.

For example, if you have $100,000 in your account and you buy 1 standard lot of 100,000 units then this is considered to be trading with no leverage because the amount that you are buying matches the amount of money you have in your account. If you bought 2 contracts, or 200,000 units, then you would be leveraged at 2:1 because you are buying twice the amount of currency than you have in your trading account.

The more lots that you trade in relation to the size of your account tells you how leveraged you are at any given time. This is worth considering when you are trading multiple currency pairs as well because even if you only buy 1 standard lot on your first trade then if you add a new position of 1 lot on a different currency pair then you are now actually leveraged 2:1.

It’s also worth considering how much overall exposure you have to one specific currency. This is especially important even if you are trading different pairs for different reasons. If you are inadvertently overleveraged on one currency and something happens to impact that specific currency and price moves against you then you will end up with much larger losses than you anticipated all because of your overexposure to that particular currency.

For example, if you are long GBPUSD and long GBPJPY then you are leveraged 2 times on GBP. If something happens to negatively affect the value of the Great British Pound then you are going to have twice the losses. This is why it’s so important to pay attention to the pairs you are trading and the real total leverage you are exposed to.

As a general rule, it’s always best to be trading with no leverage. This means that on any position that you open, you will only trade a number of units relative to the amount of money you have in your trading account. If you have $100,000 in your account then you should open no more than one standard lot or 100,000 units. If you only have $10,000 in your account then you should only trade one mini lot or 10,000 units. This will help you control your losses because if something major did happen it would literally take a 10,000 pip move against you to wipe out your account which in most circumstances is highly unlikely. If something like that does happen then there would not be much you could do about it because this is probably a black swan event and black swan events are completely out of our control.

It wouldn’t be prudent risk management to open a position size of 1 lot on an account with a balance of $500 regardless if the broker will let you or not. 1 lot is roughly $10 per pip in price movement so it would literally only take a 50 pip move to blow up the account. 50 pips is really not a lot of price movement and most currency pairs move two or three times that on a daily basis.

Being professional and trading a trade size that is proportionate to your account size is vital to making your business work over the long run. And remember that it’s not the size of your account right now that will determine your future earnings potential; it’s how professional you manage your trading account and your consistent profitability. Remember, if you can make 2-5% per month you are a hero in the Forex world!

Understanding the Relationship between the 6 Elements of Professional Forex Trading

We have now given you a few important points to consider when you are creating the risk management component of your trading plan. Risk management ties in nicely with Trading psychology because the more you risk on a trade the more this will influence your emotions and in turn, this will affect your decision-making process. If your mind is under too much pressure it tends to not perform the way that will be sensible for the success of your trading business.

What we haven’t looked at yet is how risk management ties in with the other elements of professional Forex trading so let’s do that now.

Fundamental Analysis, Sentiment Analysis, Technical Analysis, Price Action Analysis, Risk Management and Trading psychology are known as the 6 elements of professional FX trading because they are all important, extremely interrelated, and form the basis of your entire trading career as a whole rather than on their own. Let’s look at this in a little more detail now.

You are now aware that risk management is all about controlling your losses via how much you risk on each trade. But what you may not have considered is how your actual training and skill is a form of risk management as well. Let that sink in for a moment because it’s really important that your mind comes to terms with this. To explain this further we will use an example of a rock climber.

Visualize a rock climber who has 20 years’ worth of experience. He’s climbed all the most famous summits and travelled all over the world, has all the training required, has all the best equipment, and has competed in several major international competitions. Now imagine a second person who really wants to be a rock climber but instead of spending his time training and learning all about rock climbing, he is constantly trying to shortcut the process in a way that will allow him to climb as if he was a professional rock climber right away on a large cliff face. This second person has bought some second-hand equipment that he doesn’t really know how to use and has almost no safety procedures in place whatsoever.

A competition is set up and these two rock climbers are going to go head to head on a popular summit to see who will make it to the top first. But what if we know the outcome beforehand and that one of these climbers was going to make it to the top of the cliff and the other was going to slip and fall to a horrible death on the rocks below?

Now we ask you to place a bet with your own hard earned money on which of the rock climbers you think will fall to their death. Who would you pick? It’s almost certain that 100% of people would pick the amateur to not make it because it would be ridiculous to think he would make it to the top over a high-level professional with 20 years of experience.

But why is this so? Some people might argue that if they did not know the background of each climber that out of two climbers climbing in the exact same conditions surely it would be a 50/50 tossup in which one would fall. We know that this is not the case simply because one climber has done all the right things and has gained decades worth of experience while the other one has no appropriate training and no experience. This fact makes it less risky for the professional and far riskier for the amateur. The same is true in trading!

If you have the correct skills, training, and experience then the risk to you and your business are automatically reduced. Conversely, if you have no proper training and very little experience, your chances of succeeding are virtually zero. This is one reason why the statistics are so overwhelmingly against retail traders.

The point we are making here is that your training, knowledge, and practice in a professional environment is a form of risk management. The better your skills become, the greater your chances of success you have, and the harder it becomes to lose your money when you implement all of the 6 elements of professional Forex trading. This also sums up very well why most new traders with ambitions of learning from home or on their own without professional guidance tend to fail in large numbers.

Create your risk management structure professionally and as you learn more techniques and procedures focus on implementing them so that you always remain fully in control of your costs, incomes, and [Risk | risks]].

Mastering Risk Management

We have discussed this principle in various Wikis throughout this site and have discovered that the overriding principle behind risk management is that it is much more than simply how much money you risk on each trade. It’s the big picture for your entire trading business and almost everything that you do will at least have some element that directly impacts the risk that you are exposed to.

For example, if you sit down at your trading desk and you are hung over, ill, really stressed about something in your personal life, or anything else that is going to impair your emotional performance, before you even turn the computer on you have increased your risk of losing money. You have increased your risk long before you even think about placing a trade.

Risk management also comprises your knowledge, skills, and experience because these things will help you make better decisions and ultimately become a more consistent trader. The more knowledge and skill you develop in a professional manner, the better equipped you will be in the long run. The same thing goes for the more attention you pay to every area that you are going to focus on in the rest of this Wiki.

Risk management is similar to Trading psychology in that it has to become an unconscious habit that you apply to every single aspect of your trading business. If you neglect it then all the other skills you have learned, including psychology, will become irrelevant because you will not be protected from losses that could ultimately cost you money and potentially destroy your account. If you find yourself in a position where you have no money then you cannot trade no matter how good your skills are.

If there is one piece of information that we want to stress strongly is that of making you aware of the fact that the markets do not move exactly the same every single day. If you apply these techniques and do everything that we have laid out in this Wiki and others then you will be profitable because you will only be taking the best trades.

However, if you fail to protect your profits when the markets are behaving irrationally then those profits will be taken away from you. For anyone who has made a nice profit and then given it back to the market you know that this can consume you with frustration and annoyance.

It has been said that the market's sole purpose is to remove you from your money. If you think about it that’s a pretty accurate statement. The market is probably close to something of a zero-sum game. If that is true then every trader in the world is out to take your money so you have to protect yourself at all times.

Now there is no reason to worry about if you make money then someone else has to lose it because you have no idea who is taking the other side of your trade or for what reasons. You could be buying your USDJPY trade from Toyota Motor Company which is selling Yens to convert cash for operations or you could be buying it from someone who is already in a large profit. There is just no way to know for sure.

Perhaps the biggest principle of risk management is learning when to trade and when NOT to trade. You will be consistently profitable when you have mastered the art of conducting analysis and selecting trades in conjunction with being tuned into the market and realizing when it’s best to stay out.

If in several months from now when you feel like you have all the skills to make a profit but for some reason you are always losing you need to remember this lesson and begin working on your profit protection over anything else. Profit protection is knowing when to trade and when not to trade, it’s that simple.

The 4 Risk Management Defences

In the following Wiki, we are going to break risk management down into 4 distinct sections that directly impact your trading business. We will then look at how you can improve each of these. We are also going to start thinking of risk management as being a collection of different defences to your trading business plan.

Specifically, we will explore The 4 Risk Management Defences including:

You can access the main Wiki for The 4 Risk Management Defences HERE.

Having an Edge in your Trading

Having a trading edge is absolutely essential for success no matter what market you are thinking about trading in. Without an edge, you will not have any real concept of how you should place trades or go about tracking the results you are getting from your trading efforts.

In the following Wiki, we will discuss having an edge in your trading including:

You can access the main Wiki on Having an Edge in your Trading HERE.

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