Risk Management: How to avoid losing your shirt while trading Forex.
“I followed those trading signals, and my account dropped 70% in 3 days.”
“I tried this method and got margin called in less than a week.”
Let me put this simply. It doesn’t matter if some trading method, trading room, signals service, or anything else has a perfect reviews and a 5 year history showing that it never had a single losing trade. It doesn’t matter if it’s endorsed by Felix, Crazy Cat, Sir Pipsalot, me, and the heads of the IMF, ECB, and the US Treasury. Not matter what “proof” is offered, no matter how well endorsed it is, no matter what the guarantee is, DO NOT EVER RISK TOO MUCH OF YOUR ACCOUNT ON ANY ONE TRADE.
No human, no computer, no “perfect” signals or other trading method can be right 100% of the time. It’s possible to backtest and optimize something so that it’s “perfect” with old data, but the forex market is an unpredictable beast. Good systems and signals can be right much of the time, but NOTHING will ever be right 100% of the time if you let it run long enough.
Risk Management is the concept of having a plan that sets a maximum amount of risk that you will place on any one trade. How much risk is “too much” risk is the subject of much debate. I’ve seen numbers ranging from 1/2% to 5%. Some of this will depend on the forward tested success rate of your system, and some will depend on what you consider to be an acceptable level of risk.
“But if I don’t risk much, I can’t make much.” is a common complaint against risk management. To some extent, this is true. On the other hand, if you have nothing in your forex account to trade with, you won’t make any money at all. If you risk too much and there’s a big gap in price (or your broker gives you too much slippage), you can not only lose all the money in your account, but you can possibly even end up OWING money to your broker.
Let’s say you have $10,000 in your account. Then you decide to risk $5000 for the chance to make $5000 (a 1:1 ratio). If the trade goes your way, you have $15,000. That’s great, but what if it goes the other way? Then you only have $5000. Now, you need to double your $5000 to get back to where you started. If you risk half your account again and the “99% accurate” system fails you again, then you only have $2500 left. Now you would have to quadruple your account to get back to where you started. Fail one more trade like this and you have only $1250 left. You would have to have more than 5 perfect trades gaining 50% each time to get back to where you started. After 3 losses in a row wiping out over 85% of your account, would you really want to trust this trading method to work 5 or 6 times in a row now?
Let’s say you feel like using the highest end of typical risk management recommendations and risk 5% of your $10,000 account on each trade. Once again, we’ll use a 1:1 ratio just to keep the math simple. This means you’ll risk $500 on the first trade while hoping to make $500. If the first trade goes bad, you have $9500 left. You would have to lose many trades in a row to lose half of your account, and far more to go all the way down to $1250. It is true that you won’t be able to make money as fast, but what good is making huge sums of cash if you can lose most or all of your hard earned profits from a single bad trade.
I would NEVER risk more than 1/2 percent of my account per trade on something I hadn’t personally forward tested on a live account for an extended period. If I have confidence in a system that I have tested live over time, I slowly and carefully scale up the size of each trade. I’m not going to say exactly what my personal maximum risk is, since I want you to select your own, not just copy what I do.
If you want to try something new, first try it with a demo account, but remember that demo accounts get filled quicker and have little or no slippage. A real account is much more likely to have slippage and requotes, thus cutting into potential profits. If demo testing looks good, then move it to your live account and trade the smallest amounts possible, just to see how the trading works with your broker.
The Daily Trading Signals here at the FPA are a good example of how different demo and live accounts can be. It’s not that hard to catch a news spike (or to straddle the price with pending orders) on a demo account. With a live account, even the best broker won’t fill every order perfectly if you try to catch the news spike. Some brokers even go so far as to prohibit news trading. This means that if you make a profit trying to catch a news spike, they will confiscate it. Somehow, they never will give you a refund if you lose money on a news trade. Since I’m primarily a technical trader, this isn’t a problem for me. If you really want to try to catch news spikes, Felix strongly recommends MB Trading. I haven’t tried them out for news trading, so I can’t give a personal opinion on this.
If you are using forex signals or some other system and you have successfully traded it for long enough to be comfortable with it, ask the signals (or other product’s) support staff what the maximum risk they recommend is. They should be more familiar with the product than anyone else. Just remember to start small on any new system and never to exceed your own personal maximum risk per trade no matter what anyone else says.
Although a historic record of pip gains for a signals service, trading room, or trading method is a good thing to consider, the actual results you get will always be a little different. See where I’ve been reporting the results of my tests of Intelli4x’s signals. At the moment due to pure dumb luck, I’ve actually been doing a little better in total pips on the trades I’ve taken than the “official” record for the signals I’ve taken from them. Sometimes I’ve entered a little better, sometimes I’ve missed a close signal and something went on and hit the take profit number. If my schedule had been a little different, this could just as easily gone the other way and cut into the results.
Setting your risk is easy with most brokers. You just need to set a stoploss on each trade. Remember that xxxUSD pairs are worth $10 per pip for a full lot, $1 per pip for a minilot, 10 cents per pip for a microlot, and 1 cent per pip for a nanolots. For other pairs, it’s a very good idea to check a pip value calculator. If you wanted to take a maximum risk of $100 on a trade, then you can only set the stoploss to a mere 10 pips if you plan to trade a full lot of a xxxUSD pair. On the other hand, you can trade 5 minilots and with a 20 pip stoploss or 1 minilot and use a 100 pip stoploss. Usually, the stoploss is determined by your trading method and then you need calculate the maximum lot size of the trade that you can risk. If the smallest amount your broker will let you trade would exceed your maximum risk, skip the trade (or find a broker that lets you trade smaller amounts).
Remember, some brokers are better at closing your order exactly where you set the stoploss. Others frequently have very bad slippage and will fill your order at a price that is worse for you. If your broker does this too often, reduce your total risk per trade to compensate for the potential slippage loss and look for a better broker.
If you plan to leave an order open after the New York trading session ends on Friday afternoon, be aware that there might be a gap in price when the Tokyo market opens (Sunday evening in New York). If price gaps across your stoploss, you could lose a lot more than you planned. Alternatively, some brokers won’t observe the stoploss under these circumstances and the price could continue to move against you even more. Until you have a solid understanding of market dynamics, your broker’s methods, and understand all of the risks involved, you might want to close all positions on Friday before the market shuts down for the weekend and then re-open them when the market opens on Sunday.
My personal advice for ANY trading method you are considering would be to start with a combination of backtesting as well as forward testing on a demo account. Don’t base your decision to go live on 1 or 2 trades. Remember, coin tosses are accurate 1/2 the time, and getting heads or tails 3 or even 4 times in a row isn’t that hard to do. Once you have enough data to feel confident, trade TINY amounts of money live to make sure that the method can work under real world market conditions with your broker. If it’s still profitable, scale up at a reasonable pace, but NEVER exceed the maximum amount of risk per trade that you set for yourself. Even the best system in the world will still have an occasional losing streak.
Always remember this. You can’t make your fortune if you lose most of your account on a few bad trades. To get rich trading forex, you must first learn not to go broke.
I can’t promise that following this advice will absolutely save you from losing all of your money, but at least you’ll lose it slowly enough that you’ll have a chance to improve your trading technique before blowing your account.