Chapter 4: Basics Of Risk & Money Management

If you have some experience with trading or maybe other ways of financial investing, you have probably heard that risk management is one of the most important ingredients to long-term sustainable profits.

Stop Loss

Placing a protective stop loss order on all of your trades is critical to whether or not you will ultimately succeed in Forex trading, especially in the beginning of your trading journey.

Sometimes in the market, there can be sudden sharp moves in one or both directions. Not using a stop loss in such extreme cases literally exposes you to lose all or a huge part of your invested capital. In contrast, always using a stop loss generally accounts for early exits on losing positions, and the trader loses much less in the end than if he didn’t use a stop at all.

Now, let’s look at two ways traders generally use to place stops.

A not so good way to decide the size of your stop loss is having a fixed pip stop loss, that is using the same predefined number of pips as the size of the stop loss. This is seldom a good strategy to place a protective stop because it’s not based on anything other than your willingness to risk a certain amount of money or your pain threshold. Trading according to your emotions is always wrong and the same is true for stop placing because the market doesn’t care what you feel and how much you are prepared to lose. Instead, it will always go where it wants to and by how many pips it wants to. You can not affect the market in any way, therefore knowing this you can see that using a fixed stop simply doesn’t make much sense because it’s based on YOU rather than the MARKET.

In contrast, a much better strategy is to always consider your POSITION SIZE before taking a trade. Your position size for each trade should be determined based on the size of the stop loss that your strategy suggest is appropriate.

As an example, consider a trade according to your trading strategy where the size of your stop loss should be 50 pips and on different trade the stop loss should be 100 pips. This automatically means that on the second trade your risk is twice as big compared to the risk of the first trade. To make the risks equal for both trades you carefully use position size to adjust for the risks determined by the market environment. In this case, if you entered the first trade with 0.5 lots, then for the second trade the appropriate position size for you is 0.25 lots.

Position Sizing

Position sizing is the ultimate biggest factor that determines your risk with every trade. Understanding all the implications of increasing a position’s size is crucial to correctly understand the risks you are involving yourself with. Just to illustrate with an example, consider you have one opened trade in your account with a position size of 1 lot. A size of 1 lot usually translates to a 10 dollar value for every one pip move in the market. This means that a 100 pips move will equal a $1000 loss or gain in your account only because of this one trade.

On the other hand, consider you have 10 opened trades in your account all with a position size of 0.1 lots. Although this is a much more flexible strategy than having everything in one basket, you are holding a total market exposure of 1 lot.

Risk:Reward Ratio

Finally, the risk:reward ratio is the last piece that determines your risks when trading forex. In essence, it poses the question of how much is your possible gain on the trade, and is it worth risking a certain amount of money to have the possibility to win the gain?

Most often it is recommended to have at least a 1:2 or sometimes a 1:1 risk-reward on any one of your trades. Of course, the higher the reward compared to the risk the better it gets. Risking as much as you may gain, or a 1:1 risk:reward ratio is absolutely the bare minimum for taking a trade. Always be careful to consider the risk-reward of each trade before you TAKE the trade, or otherwise, you may find yourself in a trade where you are risking more to gain less which is both unprofitable and ultimately stupid.

Now, keep in mind that as you develop your trading skills and you gain more experience, depending on market conditions you will likely be able to judge which trades are higher probability than others and thus sometimes you will be sure in taking trades with a 1:1 risk-reward ratio and other times you will be reluctant in taking a trade with a 1:3 risk-reward ratio.