Having a Risk Management Plan is a hallmark of successful traders. If anyone is seriously looking to become a consistently profitable trader over the long run then they would be well served by creating and defining a risk management plan that covers everything they need to do when engaged in trading the financial markets. If a trader does not create a well defined plan then they will most likely find themselves in a world of confusion not knowing what to do in certain times of adversity.
The following Wiki will cover the basics of what should go into your risk management plan.
This Wiki is a part of our larger Wiki on Risk Management. It is also part of our Essential Forex Trading Guide. Be sure to check that out HERE.
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 [trading | 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 [trading | 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 [trading | 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 [trading | trade]] manually. This ensures that you have all the available information at the moment of entry. If you identified a good [trading | 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 [trading | trade]] anymore. Entering manually also allows you to assess your conviction level for the [trading | 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 [trading | trade]] or lower your conviction level. Entering the market at a time when the odds of winning a [trading | 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 [trading | 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 [trading | 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 [trading | trade]] is probably the most important thing to get right because it will most directly impact the entire outcome of your business. Most professionals [trading | 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 [trading | 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 [trading | 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 [trading | 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 [trading | 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.
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