Risk in life comes in many forms.
You wouldn’t be sitting here trying to learn how to trade if you didn’t understand the basics of what that means.
Of course in trading, we are exposed to various forms of the word in our day to day actions. But today, I want to talk about the risk you take when you place a trade.
I have received a more than a few emails over the last few months and I figured this is worth talking about.
Today’s discussion deals with risk per trade, rather than whether forex is risky or not. Rather focus on the objective than the subjective.
This particular form of risk is the ONLY, COMPLETELY CONTROLLABLE aspect of trading, other than deciding whether to take the trade or not. Once we place the trade, it is up to both the market and trade management from that point, and you have no control over the market. And yet, although risk is the only real control we have, it is usually glossed over or discussed in passing all too often and much of the focus becomes the analysis, the entry, the stop, etc…. I know there are those of you new to forex and trading, and you should have a place to learn this vital information. Oh sure, it sounds simple. Risk is what you risk. And yet I see so many people not be able to understand how pips and risk work together, how a stop loss affects your risk, or how to place orders that correctly “risk” the right amount. Well, we will clear this up today!!
Risk Management In Forex
First of all, we should discuss how we generally gauge risk for each trade. Many new traders will focus on bigger stops = bigger risk and small stops = small risk. An example to disprove this:
Let’s say we have a $1000 account. Trader 1 is going to “risk” 20 pips and trader 2 is going to “risk” 100 pips. Who is risking more??? If you can tell me at this point who is risking more of their account, you DEFINITELY need to finish reading this article and reassess your understanding of this subject. The rest of you are now saying…….”Hey, don’t I need more information?” Yes because:
Trader 1 uses a 1.00 lot to place his trade and loses. 1.00 lot size converts to $10/pip X 20 pips (stop loss) for a grand total of $200 risked or 20% of the whole account!
Trader 2 uses a 0.01 lot to place his trade and loses. 0.01 lot size converts to $0.10/pip X 100 pips (stop loss) for a grand total of $10 risked or 1% of the whole account.
So the trader that “risked” 20 pips actually risked TWENTY TIMES the money of the trader that had the 100 pip stop loss.
Obviously if they used the same size lot, THEN the risk for more pips would be a bigger dollar amount than the amount risked on the smaller stop. Yes, this is important but only one part of the dynamic. Our total risk per trade becomes a calculation between stop loss and lot size (without doing anything exotic like scaling out during drawdown, or scaling in during drawdown). Both stop loss and lot size become VARIABLES that need to be adjusted. Adjusted based on what???
Stop Loss: This needs to be adjusted FIRST and BEFORE lot size is calculated. Stop loss is there to protect your order and give you the best chance of winning the trade. It should not be based solely on your need to have a small stop. Small stops, however CAN be beneficial because they reduce the amount you have to make on the winning side to break even or make a profit. For every pip of a stop loss, you have to make at least 1 pip (because of spread and transaction costs it becomes higher than 1) to break even compared to your initial and overall risk. That being said, it is very foolish to base WHERE you place your stop simply to try to make winning easier. In my opinion it should always be placed in the place that gives you the best protection from volatility based on the type of trade that it is. Analysis should be completed before the trade is placed, and that includes the proper spot for the stop loss. Once you have established this area, then you must figure out how many pips it is from your entry. Only then should you proceed to the next step.
Lot Size: This becomes essential in understanding risk because it is how you change what the value of a pip is worth. As we know, a pip is merely a representation of “distance” the market moves in one direction or another and has NO value in $$$ until you figure out the lot size. Yes, 100000000000 pips means nothing in dollars until we know the lot size. So we have determined how many pips our stop will be, so now we must calculate lot size to risk the correct amount. So a pip can be worth 10 cents (as in a microlot), a $1000 per pip (in the case of 100 lots) and everything in between and even above. Even though we have a stop loss set and pips calculated, we are still missing one more piece of information before we can place the trade.
Actual Risk to Account Per Trade: Yes, we must determine how much of our capital we are going to risk per trade. This is done in two general forms: Fixed and %-based. Fixed risk simply means using a certain dollar amount to risk and adjusting lot size to make the pips fit that dollar amount. So if we are risking $100 per trade, then we adjust lot size to make our total risk hit that number based on our stop loss.
Example 1) $100 risked with a 20 pip stop = a lot size of 0.50 (or $5/pip risk X 20 pips = $100)
Example 2) $100 risked with a 100 pip stop = a lot size of 0.10 (or $1/pip risk X 100 pips = $100)
You can see from above examples that even though the stop losses were very different, the risk to the account did NOT change. We always risked $100 in the example whether its 30, 50, 75 pips etc….
Risk Management in Forex
% risk is similar in the sense that we have to adjust the DOLLARS risked BASED on the ACCOUNT SIZE and % desired. This has advantages over fixed risk in the sense of it being the “Goldilocks” scenario, that you are never risking too much or too little on any trade. The “gold standard” for prudent, good trading is 1-2% per trade. Of course, this number is up to the trader and some traders risk much more than this (trader 1 from the very first example), and some risk less (trader 2 from the very first example).
The advantage with using % risk though is that the risk changes as the account grows and shrinks (although hopefully more growing than shrinking!!). So even if you lose a string of trades consecutively, you are lowering your risk with every loss to compensate for the smaller account and it is theoretically impossible to lose all your money this way because you are only ever taking a small percentage of what you have no matter how small it is. Of course, there are things such as margin requirements and if you lose dozens and dozens of trades in a row on a small account, you may not have enough money to place the minimum order size. But it also works on the way up. As your account grows, you continue to risk a constant percentage and your lot size will grow to properly reward you on wins. After all, it doesn’t make sense to only risk $100 on a multi-million dollar account, because the gains will probably be small compared to the account, therefore prohibiting strong growth.
So % risk is the flexible way to keep a smooth equity curve in both directions and protect you from blowing out too much of your account on any single trade or not risking enough to make a meaningful gain.
So now that we know these three variables and how they work together, we will never be mystified about the basic understanding of how much we are risking per trade. The final calculation becomes:
(Account Size X %-Risk)=Dollars Risked.
Dollars Risked/Pips on the stop loss= Dollars Risked Per Pip.
Dollars risked per pips translates into lot size, and viola!! You have all the pieces of the puzzle.
Never again will you be suckered into thinking you are not risking much because of a small stop, or are risking too much because of a big one!! And no more wondering about how to figure out which lot size to use to find out how to get to your desired dollars risked, whether that be a percentage or a fixed amount.
You cannot change whether the market will go in your favor or not. With every trade we must assume there is a chance we will lose. But with that being said, we have full control over how much that loss will be and a prudent way of figuring out how to get there with our trade!!
There is a completely FREE forex risk management tool you can download here: Pecunia Systems then go to the downloads page
Author: Omar Eltoukhy
Risk Management in Forex