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Many new traders wrongly assume that all it takes to become successful in Forex trading is to identify a profitable strategy that they can follow. Perhaps they identify an indicator that seems to produce timely signals for market reversals or identify a price action pattern that tends to deliver a certain outcome. Traders will then set about designing a trading plan based on these ideas for entering the market, hoping to catch a nice profitable move each time. However, often times traders are focused on the wrong elements and the majority of their attention is simply focus on finding a way to enter the market, in hopes of catching a big move, without much thought for anything else.
One of the key factors that differentiates traders who become consistently profitable and traders who continue to struggle year after year is a solid understanding of risk management. Traders who spend the necessary time building an understanding of risk management and utilising sound risk management within their trading plan will have a far higher chance of success than traders who merely focus on their “strategy”. (Top 5 Forex Money Management rules)
The term Risk management is quite an overarching term, but as the name suggests, it simply refers to how traders manage their risk when trading and encompasses several key areas such as stop size, risk:reward ratio, position sizing, leverage, total exposure and a few others that we will look at.
For traders who have done some homework on risk management it will seem obvious, but one of the golden rules to achieving success as a trader is using a stop loss. Setting a stop loss on a trade gives you an automatic exit on any trade and limits your loss to that level. Far too many traders enter trades without setting a stop and as the market moves against them they panic and don’t know where to exit the trade. This typically leads to new traders taking unnecessarily large losses on trades which damage their accounts.
Setting stops is the foundation to risk management and traders should have developed an understanding of their necessary stop loss through stringent back-testing. A good stop loss is one that makes sense to your overall strategy. It needs to consider the volatility of the instrument and the time-frame you are trading and needs to allow enough room for the market to move, whilst not being so wide that it compromises your risk reward.
Many experienced traders have different views on stops, some believe in using wider stops to allow the market “room to breathe” whilst other believe in using tight stops so that either you are right on a trade and price moves quickly in your favour or you are stopped out for a small loss. Both have pros and cons; wider stops do indeed give you more room and can help you stay in trades that might have been stopped out by a smaller stop, however they also require much bigger profit targets to make sense financially. Similarly, smaller stops have the benefit of lower risk meaning that you can play for smaller targets and still achieve a good risk:reward ratio, however, the chance of you being stopped out is far higher. Again, a thorough back test of your strategy will help you establish your required stop loss size.
Your stop loss forms the bed rock of your risk management approach as once you have your stop loss established you can begin to calculate key functions of your risk profile. The first calculations that need to be work on are your risk:reward and your position sizing.
The idea of risk:reward is one that many new traders usually come across part way in to their learning journey after experiencing some hardship in trading. Entering a trade and hoping to catch a big move is simply akin to gambling and traders need to take the time to identify their risk:reward to establish the worthiness of their strategy and whether it needs to be altered or indeed replaced.
The key point with risk reward is that traders should always be looking to make more than they risk on any trade. Provided that the trader has a positive risk reward ratio and a high enough hit rate, they will be successful in the long run.
Many new traders wrongly believe that profitable trading comes as a result of achieving a high hit rate. The traditional perception of success is that it involves winning a lot and many new traders aim for strategies with high hit rates. Indeed, it is far more common to hear new traders discussing their hit rates than their risk:reward ratio. However, it has been proven time and time again that a positive risk:reward plays a far bigger role in achieving trading success than a hit hit rate.
Many new traders often get lured in by companies selling trading strategies which boast 80% and 90% hit rates. However, what the traders fail to realise is that whilst these strategies may indeed operate with a high hit rate, their risk:reward ratios are so poor that in the long run they don’t make any profit.
A good example is a scalping strategy that has a 50 pip stop and a 5 pip target. The logic behind the strategy is that the setups is far more likely to deliver the 5 pip target than hit the 50 pips stop. This may indeed be the case however, because the stop is actually 10 times the size of the target it means that for every losing trade you take, it wipes out 10 winners. This is what we call an inverse risk:reward whereby you’re risking more than you stand to make on a trade. Whilst it is true that you can typically achieve a higher hit rate, the size of the losses is what ruins the strategy.
Many traders operate a 1:1 strategy whereby they risk as much as they stand to make on a trade. Whilst this is far superior to an inverse risk:reward ratio it can be difficult to achieve anything beyond low level profitability.
Let’s look at two traders. Trader A has a 60% hit rate yet Trader B has only a 30% hit rate. Most new traders would assume that Trader A is far more likely to be the most profitable of the two. However, without knowing their risk:reward ratios it is not possible to know for sure.
Let’s say Trader A has a R:R ratio of 1:1 and Trader B a R:R ratio of 3:1. This means that for every 100 trades trader A makes he will have won 60 making 60R but lost 30R meaning he will have a total return of 40R.
However, Trader B winning only 30 trades out of 100 but making 3R on each wining trade will come away with 30R (90R – 60R)
Here you can see that the hit rate is actually far less important than the risk:reward ratio. Obviously the two need to compliment each other; there is no point having a 3:1 risk:reward ratio if you only have a 10% hit rate. However, identifying your risk:reward ratio for your setup allows you to work out the hit rate your strategy needs to achieve in order to be profitable and so properly identifying your risk:reward is a key part of a trader’s risk management process.
Once a trader has studied their backtest results an identified their stop loss size and hit rate, they can then start to think about position sizing.
One of the key mistakes that many new traders make is placing far more attention on working out how much they stand to make than how much they stand to lose. One of the golden rules of trading is capital preservation.
Let’s say a trader has a 50% hit rate and a 2:1 return which means that over 100 trades they can expect to make 50R (100R – 50R). They might then be tempted to risk 4% per trade thinking that over 100 trades they will make 200%. However, what they have overlooked in this equation is the significance of draw-downs.
If a trader has a 50% hit rate and can therefore expect to lose 50 out of 100 trades, they need to position with a max drawdown in mind. A trader might have a 50% hit rate and during their backtest have taken a max drawdown of 10 losing trades in a row. However, they do not know what the future distribution of results will be like and so in the next 100 trades there is a possibility that they could suffer, 20, 30 maybe even 50 losing trades in a row. The trader therefore needs to set their position sizing with their max drawdown in mind to make sure that if the worst happens, they are still able to continue trading.
In this case, with a hit rate of 50%, the trader needs to set a conservative size of 0.5% – 1% per trade. This means that over 100 trades, if 50 were lost in a row, he would only suffer a 25% – 5-% drawdown whereas sizing at 4% would mean the account would be blown up after the first 25% trades were lost.
It is vital that traders consider their drawdowns when setting their position sizing and not their potential gain. Obviously, setting position sizing too low limits the profitability of the strategy but it is better to start of small and work your way up then start off too big and have to dramatically cut your size.
As well as considering risk per trade traders need to also consider various other risk calculations which need to be built in to their risk management process.
Traders need to also be aware of what their max risk is ant any one time and also, what their max risk is per currency.
A common mistake that many new traders make is in gaining over-exposure to one currency pair. The trader monitors the markets looking through their range of tradeable pairs waiting for a setup. They then identify several setups occurring at once, typically across one currency complex and seek to take all the setups. An example of this would be looking to buy EURUSD, EURNZD, EURGBP, EURCAD, EURJPY. Whilst the trader might think their risk is diversified as they are five separate trades, they all represent long EUR exposure and so they still have concentrated risk.
Traders need to set an acceptable max risk per currency to ensure that they don’t end up overexposed and in a situation where they risk taking an unnecessarily large loss.
This also extends to max account risk in play at any one time. Whilst traders should use their backtest to establish what their risk per trade should be, they need to also look at what level of account risk they can safely utilise. Once they have taken the time to study their backtest results and consider these different risk allocations, they might find themselves using much lower position sizing than they had originally planned. This is the point of conducting risk management and will ensure that you are able to preserve your capital and keep trading to achieve consistent growth instead of hitting a few good streaks then blowing up your account because you are oversized.
Remember, you can always scale your position sizing up as your account grows but if you have to reduce your position sizing as your account shrinks then it takes even longer to recover your losses.
Once we have established our stop loss size, worked out our position sizing and have confirmed our max account risk and max currency exposure we have the foundation of our risk management approach. These are the core aspects that we need to focus on. Once these calculations, which form the basis of our strategy, are in place we can then consider operational risk management. This relates to the dynamic risk that we encounter as we trade such as spreads, holding over the weekend, news events and more.
Many new traders overlook the impact that varying broker spreads can have on their trading strategies. Typically, where this comes into play is in stops being triggered prematurely and technical setups being missed again because stops are not accounted for. If traders are manually backtesting a strategy, there is a tendency to overlook factors such as spreads and slippage.
For example, let’s say that a trader has strategy whereby they look to sell each 50% Fibonacci retracement in a bearish trend. What will typically happen is that they will set their orders on the fib levels just as their strategy dictates but when they check their trading terminal at the end of the day they might find that only some of the trades have triggered.
Another key area where spreads need to be considered in your risk management are with stop loss placement. As with backtesting entries, many traders backtest stop levels without considering broker spreads which may mean that your stops get triggered prematurely. This can be especially true when trading pairs with higher spreads such as cross pairs. Traders need to conduct a full analysis of their broker’s spreads as part of their risk management process to assess how they will impact their strategy.
For example, if a trader has backtested a scalping strategy on EURJPY that relies on a 5 pip stop and a 10 pip profit target but then realise their broker has a 3 pip spread on EURJPY this means that they will effectively be seeing their stop triggered after two pips of movement and they will be banking 7 pips profit instead of 10. This can lead to dramatically different live results when compared the back test results.
Many traders often underestimate just how much impact varying forex broker spreads can have on their strategies performance; this is especially true where traders are conducting their backtests manually.
Another key area to be considered as part of a trader’s risk management process is that of holding trades overnight. Many broker spreads widen significantly overnight as liquidity dries up. This again can lead to missing entries on orders and or stops being triggered early. To properly account for varying spreads, traders should conduct a full analysis of their broker’s spreads and work out their impact on their strategy at different levels. E.G if a strategy has a 30 pip stop and a 90 pip target and does 20% a year on a 6% drawdown, what does the same strategy do if the stop is increased to 40 pips. Traders need to be fully aware of the difference these varying spreads can make to their overall performance and will typically find that strategies need some consideration when operated in cross pairs to account for the wider spreads, especially when holding overnight.
Holding overnight is not the only time that exposes a trader to higher risk. Holding over the weekend can be particularly challenging and for many traders is not advised unless the position is already well in profit and the stop is at breakeven.
The Weekly market open is often a time of volatility for FX markets as pairs have a tendency to “gap open”. This means that instead of opening up at the price they closed on Friday, they open at a different level. Typically, the cause of these weekend gaps is a news report or risk event over the weekend which causes a significant change in order flow so that when price opens it actually opens at a different price based on the underlying orders in the market. This is particularly prevalent whenever there is any geo-political risk in the market such as the Greek crisis of 2015, Chinese market volatility in 2015 or Brexit earlier in 2016.
Often times traders will find themselves getting stopped out of positions as the market gaps open, only for price to then reversed and continue without their trade in play. Although there will be some times when price gaps in a trader’s favour, from a risk management perspective it is better to close the trade out on a Friday and look to re-open it where possible on Sunday so as to avoid suffering any adverse price gaps.
The final area that should be of prime importance in a trader’s risk management process is that of Event risk. News events are the main source of volatility in Forex trading and can have a significant impact on trading performance. Many new traders who view news events as merely a great opportunity to make a lot of money quickly, often find themselves suffering large losses. As with all of the areas discussed so far, traders need to properly consider the implications of news related volatility on their strategies to establish clear rules on how to trade around news events.See news events calendar here:
Some of the common problems faced by a lot of traders are: Orders placed ahead of key news events getting stopped out as spreads widen, trades entered on “News spikes” getting filled at disadvantageous levels. Often times traders will look to enter a trade on the burst of volatility that occurs in response to a news release. The trader anticipates that the market will move quickly in their favour and they will make a good profit. However, what often tends to happen is that because price is gapping on low liquidity, the next available price that the trade can be filled off is far off the price the trader originally tried to execute at.
Many ProfitF traders benefit from conducting full analysis of how event risk can impact their strategy and should look to build in operating procedure such as no entering positions 5 minutes head of news or five minutes after, moving to breakeven on any open trades or reducing size.
As you can see there is quite a lot to take into account as part of the risk management procedure but taking the time to properly consider all of the aforementioned will make you a much better trader and will ensure you have a much more stable and consistent strategy leading to sustainable profitability in the long term