Hello and welcome to another episode of the bulls vs the bears. Yes, you do need to practice management or you will die as a forex trader.. No, you wont die a physical death, but you will die a financial death through taking reckless risks on your trading position and your trading account. If you’ve gotten the hint by you you’d know that we are going to be touching on risk management
Now what is risk management? risk management is managing your losses so you don’t bow your entire account into smithereens management is absolutely crucial for your trading account for it teaches you discipline and patience as far as deciding how much money you can afford to let go without getting a hernia in case the trade goes south.
Unfortunately risk management has become this elephant in the room that nobody wants to talk about. Why? because a lot of traders just jump into the forex market with total disregard for the size of their trading account . They just decide how much of a humongous loss their emotional shock absorbers can handle and then hit the “trade” button.
Of course,their money ends up in a Black Hole, and then they blame forex market for it. Newsflash! You played yourself on this one. You need to follow risk management rules that will help you make profits. If not, you’ll end up gambling your entire account away.
So here are a few risk management rules you need to follow. First,
Never Risk More Than 2% of Your Trade
The rule of thumb in the forex trade is that you never risk more than 2%of your trade. Let’s take a look at an illustration of a table comparing a 2% risk to a 10% risk.
|TRADE #||TOTAL ACCOUNT||2% RISK ON EACH TRADE||TRADE #||TOTAL ACCOUNT||10% RISK ON EACH TRADE|
See the difference between risking 2% of your account compared to risking 10% of your account on a single trade? Let’s say you lost 19 trades in a row, on 10% risk, you’d have lost as much as 85% of your trading account, leaving you with a paltry $3002. Whew!That would definitely have cost me a few sleepless nights, not to mention major migraine headaches.
On the other hand if you had risk the 2% like we suggested, you’d have lost only 30% of your account.- leaving you a healthy $13,903. Now although that’s money lost, it’s a whole lot better than losing a whopping 85% of your account. And you will have enough money to trade with.Also, you don’t dwell too much on this loss.You move on and learn from this loss because you can afford to sleep at night without having recurring nightmares, unlike the 85% bust.
What’s the point of this illustration? you need to set up risk management rules such that you still have enough money to trade on the market. Now assuming that you blew up 85% of your trading account, you’d have to make up an insane 566% of the balance in your account in order to break even. Now why would I want to put myself through this stress?This is why I stress the importance of not risking not more than 2% of your trading account. Now I guess the next question some of you want to ask is:
How Do I Get Back to Break Even Point?
This table ought to show you how to get back to break even point.
|LOSS OF CAPITAL||% REQUIRED TO GET BACK TO BREAKEVEN|
As you can see, when you lose money, You end up having to make up for lost cash. And nine times out of 10, it’s an uphill struggle. It’s also the more reason why you do everything in your power to protect your trading account like a lioness protecting her cubs. Because you lose your money to the Black Hole, it is near impossible to make it all back.
By risking a smaller percentage of your account you give yourself the opportunity to get over your losing streaks and avoid a total meltdown of your trading account. The moral of the story is be calculating with your risk taking or you’ll end your money away.
Set A Risk/Reward Ratio
Another method of managing your trade risk is to set a risk /reward ratio. Now a risk/ reward ratio is basically the amount of money expect to gain on a trading position relative to what you are risking in the event that you incur a loss on your trading position.
One thing you need to understand is that the risk-reward ratio is not a set formula. You need to find a positive ratio for your risk strategy. This way you increase your profit margin when you hit the jackpot as compared to losing your money when you strike out.
Some of you are probably wondering”Why do I need to set a risk-reward ratio anyways?” Well,the simple truth is you do not want your losses exceeding your profits. A lot of traders risk too much of their cash on losing positions than they do on winning positions. In so doing, they end up using negative risk/ratio, which requires a higher winning percentage to make up for your losses. You do not want to be in this situation.
Just create a workable winning risk/reward ratio that you can live with. Most experts say a 1:2 ratio is the minimum formula for maintain healthy profits. In other words, you only need to have one winning trade for any two given losses to net to break even. This way,you maximize on winning profits while avoiding potential tsunami-size losses should the trade do a 360 on you.
Let’s look at the EUR/BP pair in price action
This is a sample range on the 4 hour time frame for the EUR/BP pair. As you can see traders are looking to make their entry at the resistance barrier around the .8575 level. When setting your stops,make sure you set them just outside the support or resistance level. So in this instance you set it at the resistance level. So that in the event price breaks through the range, you lose no more than 50 pips.
However, you can make at least twice as much in profit by placing a limit order near the level of support at .8475. In so doing you create the 1:2 ratio that I was talking about earlier. Like I said earlier, it depends on the conditions at the time Some go for 3:1, others go as high as 4:1. You just need to use prosper discretion when setting your ratios.
If you want to know more about setting stops, limit orders and other kinds of market orders look up Forex Basics – Top to Bottom Part II
That’s a wrap for ”Practice Risk Management or Die As A Forex Trader .” I hope you ‘ve understood the importance of risking what you can afford to trade. You need to manage your risks for the health of your account and for your own sanity. The last thing you want is to play catch up just to make up for the Black Hole you’ve created for yourself.
Til next time take care.
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