Maximizing Trading Capital Through Effective Forex Risk Management
It's not hard to find random sentiments on the importance of risk management for any kind of trader. There is just a good amount of sense in the idea of making every trade with the goal of protecting trading capital in mind. It is so much easier to lose money in the forex market than it is to make it. Each trader needs to find the right risk management for their strategy and personality. Some traders have more tolerance for risk than others, but the idea is all the same; live to trade another day.
Risk and Trading Capital
The accepted rule of thumb for trading risk is 1-3% of your trading capital per trade. Conservative traders or those with a large amount of capital may feel more comfortable with 1% while more aggressive traders prefer 3%. Still, the amounts reflected allow the trader to engage in multiple failing trades without completely blowing out their account.
Brand new forex traders often start with far too much capital. You don't need to dump your entire amount into your trading account until you have a proven track record of being able to bank profit in live market conditions. Live conditions offer more challenge than demo accounts because of the additional stress and psychological factors of putting your money out there to go where it will. Until you have proven to yourself through successful trading that you can handle that stress, it is best to stick to a micro-account.
There is a belief that the flat percentage isn't the best way to go about building profit and protecting your capital due to its fluctuating nature. Some traders prefer to use a set amount and periodically review it. Instead of 2%, they may just risk a flat $100 on every trade until they have built up their account to a specific level as defined in their trading strategy.
Neither choice is a bad one. It simply depends on the trader.
The Importance of Concrete Risk Rules
Novice or inexperienced traders make the mistake of not treating their risk management with the respect it deserves. Risk management rules should be written into the trading strategy and adhered to as closely as one would follow entry or exit rules. Arguably, it is the more important discipline as it can be the difference between casual loss and catastrophic failure.
Clearly define your risk management rules and know what you stand to lose before ever placing a trade. Brokers offer the ability to size your position appropriately to reflect your risk. The pip size of the trade matters less than the numerical amount. You may place a trade at 10 pips to Stop Loss one day and 40 the next. Either trade needs to have the dollar amount tailored to it by adjusting the number of units you are trading.
Your risk management rules should become second nature to you. Live them, breathe them, and err on the side of protecting your capital.
Defining Timed Stops
A Timed Stop Loss is another tool that traders use to help protect their capital. The idea behind it is to meet a certain goal within a particular time frame otherwise back out of the trade. The reasoning is in volatility.
You can look at a traditional pin-bar formation as an example. A pin-bar shows the end of a directional push and a strong rejection of the level in the opposite direction. But how we can know just how strong that momentum is? A movement with a lot of momentum and force behind it is going to continue to carry in the direction of the reversal after the pattern prints. If it does not, we can assume that there is not enough force behind the pattern to actually drive it hard against the previous trend. The longer it takes for the trend to reverse, the less likely the reversal becomes.
If it didn't have the momentum right after the pin-bar, when is it going to have it? No one knows at that point which significantly reduces your chance for success. Thus, a trader can use a timed stop.
A good rule of thumb for candlestick patterns is to see significant movement in the direction of the trend by the close of two candlesticks after the signal; regardless of time frame. The candlesticks should have little wick on the far side of the signal, indicating that there isn't much resistance to the pair's movement.
Timed Stops are not a typical offering from most brokers. You will normally have to just wait for the amount of time you are going to and close out the trade manually at the gain or loss.
There are plenty of other traders that prefer to just place the Stop behind the pin-bar and let it be taken out naturally. Neither way is wrong. The right way just depends on the trader.
Stop Loss Placement Behind Patterns
The traditional methodology for Stop Loss placement is just behind the candlestick pattern that you are trading off of. The actual placement may also depend on the proximity of any Support or Resistance levels nearby and their relation to the pattern.
There are two ways to approach this placement. The first is to put the Stop right at the tip of the wick on the pattern. This is the advice you will see given most often in tutorials and guides. The second approach is just to place it about 10 pips behind the wick or level. Support and Resistance act more as zones than they do straight lines. So it is not uncommon to see price push up a few pips past the level before reversing. A 10 pip buffer helps accommodate that buffer zone that surrounds the level established by the pattern. If you place the Stop right at the tip, then you are only leaving room for half of the S/R zone.
Risk Management Should Define Exposure
Exposure is a subject that is not covered in enough detail in many resources. We can simply define it as taking on more risk than is appropriate through our trades. But this is different than just screwing up lot sizes or using an appropriate amount of money. It is more about which trades you take and the quantity. Let's look at an example.
The EURAUD and EURUSD are correlative pairs- meaning they often experience similar movements in relation to one another. The base currency for both is the Euro. One day, a pin-bar forms on a nice level on both charts. The other indicators line up and you are going to enter a trade on this signal. If you enter the trade, you are going to be doubling your exposure without an appreciable gain in the chance of success. A strong performance from the Euro may cause it to gain against both currencies- but what about a poor one? And the fact that they are correlative pairs means whatever happens to one is very likely to happen to the other.
How do you interpret this? You limit your Exposure and your Risk. Instead of trading both signals, you trade the one that is presented better. Which is on a better S/R level? Which has a clearer pin-bar? Which has the smoother lead up to this reversal? To take both trades would be to risk $200 on the Euro performing strongly instead of the defined $100.
Other pairs are negatively correlated- such as the EURUSD and USDCHF. One moves up, the other is likely to move down. If you plan to take out multiple forex trades at a time, it is a good idea to do some research into forex pair correlation to help limit your Exposure and Risk.
A Risk Management Template For Your Trading Plan
Below is just a quick worksheet you can fill out to include in your trading plan to help keep your Risk managed. Just cut and paste the worksheet to your own document for your own use (permission granted for personal use- if anyone cares!).
- Amount of Risk Per Trade (Unit Amount or Percentage)
- Maximum Number of Trades To Have Open At Once
- Are Any Of My Pairs Correlative? If Yes- Which and How (Positive or Negative)?
- Am I Using A Timed Stop? (How Much Time or How Many Periods)
- Where Do I Place My Traditional Stop Loss
This post was written by Dennis Heil, a private forex trader from Ventura CA. You can read more articles from Dennis over on his MahiFX author page.
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