Risk Management

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 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

We will now focus on creating your very own risk management plan and make sure that we set you up for success. When doing this you should consider the following questions:

When will you Trade?

Understanding when you will trade is important because there are various times of the day when you have a better chance of making a profit than others. An example of this is when a central bank unexpectedly hikes or cuts its benchmark interest rate. In this case, you will have a lot of volume and price movement to help push your trades in your direction if you call the direction correctly. The good thing is that we know that central banks schedule their meetings and press conferences months in advance and we can find that information on most economic news calendars.

One major rule of trading is the more unexpected the event is the more of a reaction the market will give and the more profit potential there is in the trade. In the example of a central bank unexpectedly hiking or cutting its interest rate when the market was thinking it would remain on hold is an event that would really catch the market off guard and move prices quite a bit further than normal. The market will react strongly to this type of unexpected information and this is the exact type of opportunity that allows us to enter the market and make a profit in a relatively risk-free manner. This is because we know the reason behind the move and can make trades in line with that reason.

However, if you are not at your desk during these types of news releases then you are actively missing out on the possibility of making lower-risk profits provided you know how to interpret them. This violates the principles of risk management because our goal is to achieve our targets with the lowest risk possible. Missing the best opportunities adds more risk to your overall trading. Fundamental Analysis and Sentiment Analysis will greatly aid you in understanding how the market will react to news releases.

These types of events are typically scheduled well in advance so a good time to trade is when economic events, central bank press conferences, and speeches are scheduled throughout the day. You can use an economic calendar such as the one found on the Forex Factory website to find out well in advance when these events are scheduled. Not all of these events will provide tradeable opportunities but in order to catch the ones that do you should be at your desk ready to take advantage of whatever the market gives you.

When will you Avoid Trading?

When you will avoid trading is the exact opposite rationale from picking the best times to trade but it’s still just as important to consider. We need to think about times that will actually reduce our chances of having a successful trade. Of course, market analysis and gauging sentiment will be incorporated into your trading which will naturally guide you to better times to trade because you will be looking at currencies that are moving strongly.

An example of a time when not to trade would be during a time when there is little or reduced liquidity. The more the lack of liquidity, the higher the risk and the more urgent it is that you avoid the market. Severe liquidity shortages can result in major slippage, stops not getting filled, and larger losses than originally planned which as we know violates proper risk management.

Liquidity tends to be lower towards the end of a major session, going into the weekend, major holidays, or when black swan events that take place and flush most participants out of the markets.

A black swan event is an event that deviates so far beyond what is expected to be normal that it causes absolutely massive price moves in the markets.

Black swan events can’t be predicted but many traders will attempt to trade the aftermath of these events which can be just as dangerous. This is because the normal liquidity can take days or weeks to return after these events have happened while traders try and make sense of what has happened and try to price in this unexpected information. During these times the chances of losses are greater. But crucially, the chances of larger than anticipated losses increase which in turn increases your variable costs.

How will you Enter and Exit your Trades?

How you enter and exit your trades will directly impact your risk management structure. Entering the market manually is generally considered the safest method of entering. Manual entry literally means sitting and waiting to enter a trade when the price level you are watching happens to get hit.

Having a fixed order (stop loss order), so that you are automatically taken out of the market in the event that price moves against you, is generally considered the safest for exits rather than for entries. This allows us to build a trading edge that uses manual entry and automated exits. These are considered to be the best methods for entering and exiting.

The reason for this is so that you can check the market conditions before executing a trade manually. This ensures that you have all the available information at the moment of entry. If you identified a good trade level three hours ago you should check the sentiment again before entering because a lot can happen in three hours in the world of Forex or any other financial market for that matter. If you had set a limit order then you may have gotten filled and you might not want this trade anymore. Entering manually also allows you to assess your conviction level for the trade at that moment.

The alternative is having a pending order in the market to enter when the price reaches your order. This does not factor in any possible changes to market conditions which might otherwise stop you from placing the trade or lower your conviction level. Entering the market at a time when the odds of winning a trade have evaporated is a controllable variable and entries should definitely be considered carefully from a risk management perspective.

Exits work in the same way. If your exits are not automated then you leave yourself exposed to the possibility of the trade running against you further than your plan allows during times that you are not actively at your desk trading in the markets. Also, if the market is moving fast then you will want out of your trade as fast as possible. In this case, it would be way better to have an automated stop loss order because you will physically be slower than an automated order.

How much of your Account will you Risk on each Trade?

How much of your account that you will risk on each trade is probably the most important thing to get right because it will most directly impact the entire outcome of your business. Most professionals trade with no leverage under most circumstances! Let that sink in for a moment. This does not mean that you can’t use leverage but when you do it should be very carefully planned and executed with exact precision.

Only the absolute highest probability trades with the utmost conviction levels should be considered for the use of leverage because traders that consistently use leverage without this type of planning eventually lose the money and with it their business. You can’t stay in business if you have no money to operate with which in our case is the money that we use to trade for profits.

We would also like to point out that using leverage at the beginning of your career is far riskier than after you are a seasoned professional. When you are new to trading you simply have not spent enough time experiencing the way the market moves. For example, if you have never traded during a safe haven flow then how can you expect to know how the market will react? From the writer of this article's perspective, it took about six months before he finally felt like he had seen enough market experiences with safe haven flows to be able to trade them profitably. It takes time to learn about all the different market situations and the reasons that create these situations. When you are starting out we would encourage you to try and trade with as little leverage as possible.

Ask yourself this question: If you had a business would you feel confident betting your entire future by borrowing lots of money from the bank to expand your operations if you only had a single client? Sane and logical people would probably not do this. trading is the same, every stage has to be thought out and planned through. You can’t bet the farm on every trade and expect it to last very long.

Risk management is an area that gets a lot of attention in the institutional world but almost nothing at all in the retail world which is yet another reason why retail traders tend to have a much higher failure rate when compared to that of institutional traders.

When you come across retail traders you will notice that their main focus tends to be on systems, indicators, or chart patterns. They pay almost no attention to Trading psychology or risk management which in fact are the two biggest areas that need constant attention, especially in the beginning. This is the reason that most of these uneducated traders fail and lose money overall. They are simply not focusing and learning the correct concepts in the first place so it’s completely understandable why their failure rate is so high.

Keep in mind that a big part of risk management is to decide how you will allocate and control your resources. You need to plan and set risk management criteria from the very start of your business. This is not something you should try as you go along or after it becomes obvious you need it. When it becomes obvious that you need proper risk management it’s usually too late because you might be holding a position that has a much larger loss than you anticipated or hoped for.

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 [[The_Best_and_Most_Popular_Forex_Platforms_for_Demo 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.

4 Risk Management Defences

In this section, we are going to break risk management down into 4 distinct sections that directly impact your 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.

Limiting the amount of money that you can lose on a trade is obviously a great defence to have up but there are other defences that will protect you as well. When you have all of the defences up you have maximum protection and your business is as safe as it can possibly be. When you lower your defences your business becomes more exposed and you put it at a much higher risk of failure.

This is the mindset that you need to develop so that when you decide to not use a risk management defence you do it consciously fully understanding the risk that this now exposes you to.

The biggest reasons that traders lose everything are when they unknowingly lower their risk management defences or fail to build them up in the first place. A big part of this section is about making you aware of all of the defences available and how you can go about incorporating each one into your business plan.

Before we get into each of the 4 defences we first need to have a clear plan with which to set goals.

Developing your Trading Process

Think of developing your trading process as the big picture, for not only your trading but for your business as a whole. For a trading business, your goal may be to make money but if you leave it as vague as that how will you ever know if you have reached your goals? Why do you want the money, how much do you want, and what will you do after you’ve obtained that goal? All these things are important because they will help you structure your plan and then when you have a plan you can take steps to reach your goals.

Let’s look at an example of a plan and how you can use this template to create your own.

When the author of this Wiki first started trading his ultimate goal was to be free. Free from having to work for an income, free from having to be at a certain place at a specific time, free from worrying about whether or not he had enough money to buy or do something.

Material possessions didn't really concern him nearly as much as having freedom. He already had a nice car and house but his main focus was not on buying the next best thing or material item. When he started trading he didn’t have a family to look after or any large commitments other than general financial obligations.

He personally knew traders that live for the fastest cars or the biggest house and the most expensive clothes. For them the goal is pretty simple, to constantly work their way up to afford the latest and greatest things. He also knew other traders that have families and their biggest concern was making sure that they have a stable environment for their families to grow up in and have enough money to cover all the needs of the family.

The point is that it really doesn’t matter what your goals are as long as they are clear in your head and you have a path to reaching them.

The curious thing about goals is that when you attain them you always tend to create new ones. This is good because without goals there is not much direction or point to doing anything. It’s only when you have your goals clearly marked out that you can start taking steps to attain them. When you have clear goals reaching them is inevitable if you take just one tiny step toward it every day. Consistency is the key and with that, it’s almost impossible to fail.

The first thing you need to do is have a goal. If you really don’t know why you want to be a trader and build your business then you need to take some time out and seriously consider this before going any further. We can assure you that you will be going around in circles and never really have the feeling that you are making any progress at all. After all, progress is measured by how close we are to our overall goal!

Assuming you have a goal in mind we can then start to work towards your desires and as we have mentioned before there are 4 key areas that we should incorporate risk management into if we are going to succeed. The reason for this is that we build up those multiple risk management defences that protect us at every turn. Once you have a solid understanding of your risk management defences then you can better formulate how you are going to go about obtaining your goals.

Defence #1: Money Management

Money management is the first area of risk management and is perhaps the most famous and well-covered of all the defences.

Managing your money is critical in all areas of life, especially in trading.

The concept of money management is driven by the principle of never losing all of your money on any one single trade and always being in a position to be able to trade the next day. To do this you need to have enough money in your account. This means the very basis of money management is to ensure that you never lose or even risk more money than you can afford to lose.

Leverage:

The first port of call for money management is the concept of leverage. We have touched on leverage in previous sections but hopefully, you have done enough personal research to understand that leverage is simply a way of trading with more money than you actually have in your account.

Professional traders don’t just use leverage in the market on every single trade without a lot of pre-planning and thought. The use of leverage is a tightly controlled process and there are traders that make a lot of money by using leverage but it is guaranteed that these are not just mindless trades due to boredom. These leveraged trades are carefully planned and executed using leverage to maximize the gains while there are safeguards in place to limit the losses should the trade go wrong.

The fact is that the use of leverage directly influences your level of conviction and confidence in your trades.

If you are using too much leverage your main focus will not be on the main factors that make your trade a good idea but rather on how much money you are losing as the trade goes into drawdown. This of course makes you prone to bad decisions and mistakes in your trade management.

The more leverage you use, the harder it will be to maintain conviction and clear thought when trying to implement your trade management strategy.

The other problem with leverage is that in the event of a black swan event things like your trade management plan will not help you if the market drops 40% in a few minutes. In fact, it's times like this that are precisely why you need multiple risk management defences in place.

Imagine if the markets did drop 40% as they did in late 2014 after the SNB removed their price floor on the EURCHF pair. If you were leveraged even just 3 to 1 you would have lost your entire account and then some in just a few minutes. We can’t emphasize enough how vital it is to have all of your risk management defences up at any given time. Trading without leverage is one of those defences that will protect you.

Does this mean that we can never trade with leverage? Not at all! It’s completely fine to add leverage to your positions but only when you have planned your trade perfectly and have the knowledge that if some black swan event did happen against your trade then you are probably out of the game for good.

Applying leverage now and again is ok but when you do it on every single trade eventually you may get caught out on the wrong side of a market which can be rather difficult to recover from.

Generally, we advise you to trade unleveraged and have strict risk management procedures in place to ensure that you are never over-leveraged on your personal account and especially if you are managing client accounts.

Execute each trade as per your trade plan. Many professional traders will rank each trade they take based on the level of conviction they have in that position. Any trade less than 7 out of 10 in conviction is deemed low quality while anything over 8 out of 10 is high quality.

Build the habit of applying conviction ratings to your trading. The basic idea is that you gradually start to get a really clear understanding of which trades are better than others so that you can focus on the higher-probability ones. 85% of your trades will be in the 5 to 7 out of 10 range and it is recommended that you only apply leverage to trades that have a conviction rating above 8. This is a good general guide to how often you should be using leverage in your trading which will only be maybe 15% of the time.

Another key point to keep in mind on the topic of leverage is that it’s very important that you do not become inadvertently or accidentally leveraged. This can happen in a number of ways but the following example sums it up pretty well.

Imagine that you have taken a long trade on the EURNZD pair and then later decide that the NZDUSD looks good for a short trade. What you effectively have done is taken two short positions on the New Zealand dollar. You might as well have double leveraged on one of the individual trades because if something happens in the session to really move the NZD against your position this will cause your losses to be magnified.

With all that being said, it’s not enough to simply trade unleveraged on different pairs you have to be aware of how much exposure you have to individual currencies at any given time.

The best way to approach money management is to think “what is the absolute worst thing that could realistically happen while I am holding this trade”? Then prepare yourself for that exact eventuality so that if you are holding multiple trades in the same direction on the same currency then you can plan for how you will prevent this exposure from putting your account in danger. This plan could be as simple as recognizing what you have done and cutting some of your positions. The point is that you are always aware of and protected from the downside of using leverage.

You may be thinking that if you can’t use leverage then you won’t be able to make enough money to live or reach the goals you desire. This is true and not true at the same time. Allow us to explain.

A good trader with a track record of 6-12 months at a consistent level of performance can in theory be trading 100k worth of investor or company or client money fairly soon. If you can achieve a consistent 2% per month on a tiny account of $1,000 or so people will become very interested in your trading. You might have an uncle that believes in your ability and funds an account for you or you may take your verifiable track record to a company that funds traders and start working with them.

Once the trader has a solid track record on something like 100k and has shown that they can handle managing other people’s money they are then introduced to higher net worth clients and within six months from this can very easily have several million dollars under management. Investors are hungry for consistent high-yield strategies and it is not an unrealistic target to be managing 10+ million dollars/pounds within 2-3 years of your first profitable period. Many traders choose to go the prop trading route because of its low barrier to entry.

This does assume that you can maintain your level of profitability consistently. The revenues generated from this can be substantial and more than enough to propel the lowest earning individual with the smallest account to their goals making 7 figures per year or more.

You must not have such a short-term view about trading and remember that there are opportunities everywhere for traders that can make a consistent profit over time. Patience is one of the major issues with why retail traders fail to be successful over the long run. They demand too much from the market too quickly and fail to understand that you will become a better trader over time but only if you do the correct things consistently. Traders need to view the business of trading the same as any other business that starts off small and continues to grow over the years.

Trading without leverage is very important but this is only one of our risk management defences. In the next section, we will look at the concept of trade management and how this can add an extra layer of protection to your trading account and business as a whole.

Defence #2: Trade Management

Trade management is another large part of controlling risk. This is another quite popular concept that we will look at now.

This concept of trade management revolves around your ability to make sure that each trade you take is executed according to your plan and is not allowed to get out of control. There are several strategies that traders use to manage their trades and we will go over these next.

It’s also important to note that these are not necessarily the best techniques or that other techniques don’t work. It’s ultimately up to you to find out what works best for your personality but these methods are tried and tested and do offer a very good strategy and starting point for your trade management.

Stop Losses

The first item that we will look at is the concept of using a stop loss. There are many types of stop losses to choose from.

Price Based Stop Losses:

A stop loss is simply an order in the market that you set when you enter your trade to get you out of the trade in the event that the trade goes against your intended direction. This is very common and hard stops should be applied to all trades that you enter.

When we use the term "Hard Stop" all this means is that it’s a fixed order that will automatically get triggered if the price hits a certain level against your position. Even if you decide that you want to give the trade lots of room to breathe a hard stop should still be placed somewhere just as a backup plan in case something happens or changes dramatically overnight or when you are not looking at your position.

This leads us nicely into the placement of your stops.

There is no mechanical way to place stops and the size of your stop will depend on many variables in play at any given time. For example:

• What is the average range of the pair that you are trading?
• Are you day trading or position trading for a longer-term move?
• Have you entered from a value level of support or resistance or did you just jump into the market at the current price after a news event?

As a very general guide day trading stops can be anything from 25-50% of the average daily range of the pair that you are trading. For longer-term trades, you could place a stop from anything from 100-300% of the average daily range depending on how long you intend to hold and what type of volatility you anticipate in the meantime.

Most professional traders use these types of stops because it gets them out of the markets instantly if the stop loss price is reached. It also helps with the psychology of trading because if you are holding a position it can sometimes be hard to internalize new information, especially if that new information goes directly against the position that you are in. By being out of the market and cutting the loss you can then regain focus and prepare fully for the next trade.

The most common type of stop is something called a price based stop loss. This is when you place the stop at a price where you feel the market will not get to if you are correct in your analysis.

Time Based Stop Losses:

There are other types of stop losses such as time based stop losses. This means that you will leave your positions open because you have a strong conviction that in a certain time period, the price will eventually move in your direction. The problem with this kind of stop is that they do not protect you from sudden changes in the market environment.

If you really want to trade with a time based stop then trading in the options market is probably a better way to go. In terms of spot trading a fixed hard stop should always be applied and this is considered one of your primary risk management defences.

Trailing Stop Losses:

Following on from the concept of fixed stop loss is the idea of a trailing stop. All this means is that you place an initial stop of 50 pips, for example, and as the price moves in your favour, you adjust that stop loss so that it’s closer to your entry point. As the price continues to move in your favour you keep trailing your stop behind the price until you start locking in some profit as the trade progresses.

Imagine if your trade was 50 pips in profit you could now move your initial stop loss so that if something happened unexpectantly in the markets you do not go from being in profit to actually losing money on the trade.

In real market conditions trailing your stop loss too quickly or too tight can lead to you getting stopped out only to see the market then take off in your intended direction which can be very frustrating. You need to be clever about how you employ trailing stops and use very specific tactics to give your trade the best chance of profitability.

For example, one of the most effective methods is leaving your initial stop loss in place until the price reaches a place where it’s actually closer to your target than it is to your entry. This is a very good place to decide if a small loss or a full loss is acceptable. If the trade is only 30 pips in profit and you have a target of 100 pips then moving the stop to breakeven is probably premature. However, if it then reaches 60 pips in profit you can then take action to reduce your risk and trail your stop with the reasonable expectation that the price will hit your target before coming all the way back down to take out your stop. If it does come back down at least you didn’t take a full loss on something that was in the money quite a bit.

Another common mistake in this scenario is moving the stop straight to the initial entry point. price can be volatile and intraday trading can involve a lot of noise as the markets move their way in the direction that you have identified. A very good tactic would be to move your stop to just reduce your initial risk rather than trying to eliminate it completely. If you were risking 50 pips and the market moves in your favour you might be able to reduce your risk to 25 pips, or example, if that turns out to be an intelligent spot to place the stop. Doing this will eliminate some of the times that the market pulls back and catches you out with normal intraday noise.

These are just some small things that can make a big difference in the performance of your stops in a real live market.

Another key to effective stop loss placement and management is your entry. Where you enter the market will make a huge difference in how big your stops are and how effective the trailing of your stops will be. We call this concept "Risk Reduction".

Risk reduction is where you base your stop on your entry and then manage it accordingly. For example, imagine if you have a solid conviction that a certain pair is going to sell off during the coming session. On top of this, you have identified a good level of resistance that is in the selling zone for the day, has a confluence of factors lining up with it including some large bank sell orders, and is also not too far away from the current price. From a trading perspective, this confluence is a level 9 out of 10 on the conviction scale.

You have a firm technical level from which to trade with the market sentiment. This means that we would be anticipating the price to react directly from this level should the price come to it. This in turn means that we can use a more precise stop loss order because if the level fails we know that we got it wrong instantly or that something has changed with the overall sentiment. The fact that we are expecting an instant reaction is also a very good thing for our trailing stops because if we get the reaction we know that this is the moment we want to be reducing our risks and taking profits.

Let’s visualize an example of this happening:

Pretend that we are trading a pair short because of a really strong sentiment. We have highlighted a level that has a perfect confluence of factors from technical levels to fundamental bank orders and then the price starts to rally up to that level. Remember, the further the price has to travel the more likely a reaction is so bear this in mind if you are trying to decide between a few different levels.

The price now reaches our level and we check that the sentiment hasn’t changed before entering the trade. As expected the level provided an immediate influx of sellers and the price now starts to fall away from the level.

At this point, we know that our analysis has been correct and need to capitalize so that we don’t lose money on a good trade. For each pip or set of pips that the market moves in your direction, you can then start to move your stop and reduce your risk by the same amount. On trades like this, the stop can be around 25% of the average daily range of the pair making it fairly tight. The increment of risk reduction can be 1, 5, or 10 pips for the trailing stop but this really depends on the pair and how much it tends to move around. The point is that you are taking aggressive action to get that risk down as quickly as possible while the trade is playing out in your favour.

We will talk more about selecting entries and taking profits later but this is just an example to illustrate the following key point about trade management as a risk defence.

The only reason you can be this aggressive is because you have selected such a precise entry point. The more precise your entry points, the more aggressive you can be with your risk reduction and trailing of stops. This also makes this particular defence stronger.

Now, this does not mean that entries are the most important factor because they are not. It is perfectly acceptable to enter a trade if you are slightly unsure whether or not it will move against you in the short term as long as you have a solid conviction that it will meet your target in the longer term. You may decide that rather than trying to be too clever or risk missing the entire move completely that you just want to be in and ride it out. This is also perfectly valid but without that precise entry point, you will then need to have a totally different approach to both your initial and your trailing stops.

To illustrate this we can visualize a completely different trade setup and while this is equally valid requires a more flexible approach to your stops.

Imagine that you are buying a pair because you have a very strong conviction based on the underlying fundamentals and you can’t be sitting at your desk all day long waiting for the perfect entry point. In this scenario, it’s likely that by the time you check the price again in a day or two, you have missed the move. Instead of missing the move you decide to get in now and you protect yourself from any short-term noise which could occur in the meantime.

On this occasion, your stop would need to be much bigger to allow for this. The method you use for adjusting your stop would also need to be less precise. It would be better to leave the stop in the initial position longer and then when you decide to trail it you do so only when the price has reached a point where it is closer to your target than your entry. So rather than you using technical levels to base your management on you will use much more general things like overall prices you feel the pair will not get to instead.

This concept of risk reduction should always be carried out with the following mantra in mind:

• What is the best way to reduce my risk as quickly as possible without limiting my ability to make a profit?

Just because you can move your stop loss to break even when you are up 15 pips, doesn’t mean that you should move the stop at that point because most of the time you will get whipsawed out of your trades using stops that tight. When managing a trade this way it means that the good trades wind up yielding nothing but the bad trades always become losses full losses. This can only mean an overall loss over time on your account.

As you can see that not paying close enough attention to every one of these details can hamper your trading and increase the risk of you losing money overall. This all needs to be carefully considered and taken very seriously.

Firstly, you should always have a stop. Secondly, how you manage that stop depends largely on the type of trade you are taking.

Entries and Exits

As we have looked at already, it is not just stop losses that can be used to help lower your risk in the area of trade management. Entries and profit exits are also extremely important to keep your overall risks in check.

Your entry will determine how much drawdown you are likely to suffer and will also give you a clear picture of how you expect the trade to play out. If you trade from a really high probability level then you will expect an immediate reaction from that price and know much quicker if your analysis has been correct and if the trade is going to succeed.

If you jump into a longer-term trade based on a pullback of the fundamentals this makes it much harder because we don’t know how long the pullback will last, when the fundamentals will come back into play, and what you will do if some strong sentiment appears out of the blue. These are much trickier to deal with and the point of this section is to make you aware of the fact that they will alter the amount of risk your trade is exposed to.

Your exits are just as important as entries because if you are not taking your profits then it doesn’t matter how good your trade is. You will lose money in the long run.

When you are thinking about where to take your profits you can use technical areas where price has already produced a reaction from. For example, if you are long on a pair, unless you have a really strong conviction that the price is going to break the most recent extreme highs and keep going then you should consider taking profits just before those recent highs. Expecting more from the market without a really strong reason to believe it will keep moving beyond an extreme would be foolish and you may give back a large portion of your profits on that trade. The same is true in reverse if you are selling and targeting the lows.

The reason for this is that if the price has already traded from a level recently it’s likely that when it pulls back and approaches the same level again it’s reasonable to assume that traders will be attracted to that level again. Even if it only holds up the price temporarily, do you really want to be up 50 pips only to watch the price come all the way back to your entry level? From a purely psychological perspective, this is a bad idea for your mental health as a trader.

Along with your initial stop loss and any risk reduction strategy you may have, you should always have a clear target that gives you a high probability of banking some profit which over many trades will result in an overall profit. If you have no target then you have no way of banking profits in a consistent way and if you do not have that then it will be very hard to remain profitable and consistent over the long run.

You can bank 2 pips when you see it but are you going to win on enough of those trades to counter your losses to make it a profitable strategy overall? You can also decide to hold for the long term and ride out any short-term sentiment and bank a much larger gain than you were risking which is fine but it also poses the risk of the market turning against you and exposing you to any number of unforeseen events occurring to rob you of your pips. You can't predict unforeseen events that may move the markets.

Both taking profits too early and waiting to take profits too long can increase your risk of not making an overall profit. Having said that, risk and reward on one trade is not something that you should get overly concerned about because what matters is if you are profitable over a sustained amount of time and trades.

It is not impossible for traders to scalp the market using a risk/reward ratio of 1/1 or less and become very profitable traders. While other traders manage millions of dollars taking a longer-term view of the markets and going in with risk/reward ratios of 1/3 or greater. Therefore, it really doesn’t matter what you do, the key is that your overall trading plan and execution result in a net profit.

We genuinely prefer to have all the defences up and that means trading from good levels within clear parameters riding sentiment that is strong and that lasts the entire session. But if you are a longer-term trader you will not have all of these luxuries so you must make up for that by being stricter in other areas such as money management, using less leverage, or opening fewer positions at the same time. Remember, when you lower one risk management defence you must do it in a knowing way and not because you have been sloppy or careless in your trading. You must then make sure that the extra risk you are exposed to is offset as much as possible by the other defences.

Hedging

Sometimes traders will use a hedging strategy where if the market is going against them they will accumulate a total of three trades as price moves against them. If the market continues to go further against them they will hedge all the positions with one new order. These traders will then wait for the market to get back to where the last trade was put on and close the hedge position with the thought that the market will now move back in their favour.

If the market moves against them again they will re-hedge at the same levels as the previous hedge with the same plan as before. If this happens more than twice it is usually best to close the trade altogether because it is clear that the trader has missed something in their analysis.

Although this is a valid strategy to use it’s also sort of like refusing to admit you are wrong and taking a stop loss. Sometimes the best remedy for a bad position is to simply get rid of it and live to fight another day.

Hedging is a bit of a tricky subject. There are many ways to hedge in the Forex market. It is an advanced subject that should only be taken on by experienced trading professionals who have been through many market conditions and have the trading skills to guide them through a hedge trade.

Defence #3: Self-Management

Self-management is all about managing yourself as a trader and as a person so that you can operate to your maximum efficiency. This section relates heavily to Trading psychology and has a huge amount of overlap. The reason that we are talking about it now is to express and ingrain into your mind the importance of self-management and how if you neglect it then you are basically removing a key risk management defence that can protect your business from harmful losses.

Managing yourself from a trading perspective all starts from the moment you start learning and training to trade the markets. For example, if you are learning to be a brain surgeon would you try and get the information that you need from free forums, blogs, or websites like Wikipedia?

You probably could find all the information you need. Surely spread out over the entire internet there is all the information that is required to become a brain surgeon. However, there are 2 major problems with this.

1. First is that you don’t know what you should be looking for in the first place making it impossible to filter the good information from the bad or outdated information.
2. Secondly, the source of that information is completely unknown making it even harder to make those distinctions.

No one would try to find all of the knowledge to be a brain surgeon for free on the internet and the same should be your view when learning to trade.

Learning to trade some complicated technical system from some so called “guru” is not even on the same planet as learning how to trade from an institutional trader that learned how to trade at a professional trading firm, following their guided institutional trading program, while being taught by successful traders and coaches. So your first step is to ensure that your learning continues from credible sources in a structured and proven manner which you can do by learning from all the very large Wikis we have put together. The authors of these Wikis all worked for professional firms before moving out on their own.

The next step is your ongoing research of the markets and this comes down to using the correct tools that will give you an information advantage. Finally, you will need to dedicate yourself to practicing religiously the concepts and skills you have learned so that over time your performance will improve.

This all sounds straightforward but most new traders, particularly retail traders, tend to go around in circles looking for the next best system or strategy that will do all of the work for them and make the process of trading easy. Well, trading is not easy! It is a skill just like any other and trading professionally is just like any other profession.

When you start out any new career you wouldn’t be given the opportunity to be the CEO of the company on day one. You would start at a much lower level and work your way up from there as your skills and knowledge of the industry expand and improve. The same is true of trading and being profitable. You simply don’t start off as a millionaire; you have to work your way up to that. You need quality training followed by relevant practice and experience which takes time and dedication to get to the highest levels.

The next key mistake that new and retail traders make is to stop their self-management. This is probably the biggest killer of new trading talent. In order to perform at the highest level you obviously need knowledge and experience which many traders have in abundance but the third key piece to this puzzle is a conscious awareness of your state and having some kind of structured process for reaching your best performance state.

This concept was covered quite well in the previous Wiki on Trading psychology. The main theme here is that you need to be trading in the zone in order to perform at your peak. You will never do this if you don’t take decisive steps to improve your Trading psychology and find your perfect state. This is not something that you learn and then everything is perfect from then on. Rather this is something that you carry on doing for your entire trading career. The simplest way to do this is to allocate some regular time with a professional trading coach who can work with you to help you develop the processes and mindset into regular unconscious habits. This one habit alone will put you light years ahead of almost every other trader anywhere.

The reason self-management is such a key defence is that if you are not focussed or if you are not trading in the right state then you are directly increasing your risk of losing money through bad decisions or thoughtless actions.

The overall theme of self-management is being self-aware at all times, knowing what you should be focussing on to improve your trading performance, and finally, implementing knowledge from credible sources in a focused manner. We suggest that you regularly review the Trading psychology and also incorporate personal coaching into your routines if you can find one.

Defence #4: Environment Management

Your environment will have an impact on your overall performance which in turn can increase your risk of losing money so it is worth spending some time taking a look at this section and the things you can do to improve your trading environment.

The first and most obvious is the location and layout of your trading office. If you are on a trading floor then you will have all the tools that you need at your disposal such as TVs that display financial news throughout the session and audio squawks also being broadcast for everyone to hear. A lot of professional traders prefer this type of environment because it keeps them in the loop of the action and tuned in fully as to what is going on, not to mention being surrounded by other professional traders.

The key to your environment is that it’s conducive to being able to focus on the market and tune into what is going on. This means that your desk is clear of clutter, your office is clean and tidy, and there are no obvious distractions that will make you lose focus. Make sure that the room you are in is a comfortable temperature and that the lighting is as substantial and as natural as possible.

This brings us to the trading desk. Generally, we recommend between 2 and 6 screens for your station because less than 2 makes it a little harder to stay on top of what is going on while more than 6 can encourage information overload which is just as unproductive.

A standard 3 screen setup will generally display a real-time news feed with an audio squawk and text headlines filtering through, a trading platform with all open positions and charts visible, a research screen where you can tune into the markets and catch up with things you may have missed without losing your view of what is going on and happening in the short term. The research screen will be where you look at things like articles, blogs, and analyst posts. If something happens it will be squawked and you will be right there to react as necessary.

Having an awareness of what is going on around you is also a form of risk management and if your environment is conducive to allowing you to tune in to the prevailing sentiment or volatility then you will also lower your chance of losing money. If you are correctly tuned in then you have a much higher percentage chance of actually taking the correct trade or avoiding any volatility that may be happening which reduces losses and increases your bottom line.

Having a trading desk setup that not only allows you to see this information clearly and quickly but also helps you stay focussed and concentrate is another risk management defence because its ripple effect will have a very real impact on your overall performance. If you are in a poorly lit room or an open part of your house, constantly being distracted, your chair is really uncomfortable, you are trying to operate on an old one screen laptop that keeps freezing up then you are lowering this defence and exposing your business to completely unnecessary risk.

Another advantage of working on a trading floor is the fact that you get to spend time with like-minded traders and get to sit in on the daily briefings and share in the analysis with your peers. On a physical trading floor, the goal is to always have the desks compact and close together so that traders can discuss the markets and get the benefit of the common view. Some online prop firms offer virtual trading floor as part of their service as well.

If you are not on a trading floor then it’s good to use the many instant messaging services such as Skype to build a contact list full of traders so that you can discuss things throughout the day. If you have a trade or are unsure of something having this group of traders as part of your environment will also help you stay on track. Even just an online network of traders is better than nothing at all.

As you can see, environment management can be fairly important. Although on its own, will not make the difference between you winning and losing, the impact instead will be on helping an already profitable performance or reducing the number of negative trades you suffer. But when you combine environment with everything else in these sections you will end up with a formidable risk management setup and if applied correctly will guarantee that your business will remain solvent and any losses are tightly controlled to keep you in the game your entire trading career.

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, what a trading edge is, real-world stories of what not to do, cautionary notes, system chasing and unrealistic expectations of what having an edge means.

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