part0060

In every walk of life, whether in your personal or business life there is risk. Risk is everywhere. A new business has risk, a relationship has risk, travelling involves risk, as do most sports and hobbies. It is impossible to avoid risk completely, and to do so would lead to a very sterile world. What we all attempt to do, whether consciously or subconsciously is to judge that risk, and then decide for ourselves whether we wish to accept or reject the activity, based on our assessment.

Whilst we may never think of the risks associated with driving a car, we may be more aware of the risks when crossing the road. We judge financial risk in much the same way, whether lending a small sum of money to a friend, or investing in a start up business. We assess the risk and make a decision accordingly.

Trading, by its very nature carries a high degree of risk, and as I always say in my live forex webinars and stress in the forex education program, there are only two risks in trading. The first is the financial risk which is easy to quantify and manage, and the second is the risk on the trade itself, which is much harder. In this chapter we're going to focus on the financial aspects of risk management. In other words, protecting your trading capital, which is your most precious asset.

The reason it is so precious is very simple. First, if you lose it, you are out of the market and your account will be closed, probably by your broker. Second, and perhaps less obvious, each percentage point you lose, makes it harder to recover, and gradually what will happen is your trading will become more akin to gambling, as you try to recover your losses. Let’s look at the maths, with a simple example.

The next question is this. How much, in percentage terms, do we have to regain, in order to return to our starting point of $1,000? To find the answer, we simply take our remaining capital, which is now $900, and calculate $100 as a percentage of this figure.

In other words, we have lost 10% of our starting capital, and in order to recover this amount and get back to ‘square one’, we have to make 11.1% on our remaining trading capital. This is how the maths works against us, and as the losses increase, the harder it becomes to recover.

Once again we have to recover more, in percentage terms against the remaining capital, than we have actually lost. And this is why the maths is always working against us, whenever we sustain a loss. This is why managing and keeping losses small, is the number one rule in money management, and I hope the above examples prove why.

Just to reinforce the point, consider this. If you lost 50% of your trading capital in one trade, you would have to make a 100% return on the balance remaining, just to return to your original amount. This is when trading becomes a bet, nothing more and nothing less. A ‘double or quits’ which is the last throw of the dice. You may be lucky and win, but the chances are you will lose and be out of the game, poorer and hopefully a little wiser.

The question you might reasonably ask at this stage is, why all this focus on loss, when actually we are supposed to be making money? Let me explain, as this is one of the great ironies of trading, that many new traders struggle to grasp. So much is written about making money, the prospect of making a loss is almost ignored, and yet managing losses is of far greater significance than making money. It sounds odd, doesn’t it. And yet I can assure you your focus at all times, should be the opposite of what you might think. Each time you open a new position, the focus should be on how much we are ‘prepared to risk’ on the trade, in other words how much we are prepared to lose. This is the starting point. The profits will look after themselves. This approach expresses much the same sentiment as the old saying:

This is the approach you have to develop, and I hope from the above you can understand why. If you focus on what you are prepared to risk and possibly lose, the profits will look after themselves. Most new traders, and many experienced traders, do the exact opposite, and only concentrate on the profits. Like many things in trading, we have to view money management and risk from the other end of the telescope.

Whilst trading is many things, it is in essence a battle with yourself. It is a mind game, in which, as a trader, you are constantly struggling to manage your emotions as they are driven this way and that by the market. You have to learn how to manage your emotions, dealing with the emotional pressure of a potential loss, as well as the pressure of losing a potential profit. Both very different emotional responses. I will be covering this in more detail later, but the point I want to make here, is simply this. If you can learn how to lose, and manage that loss both emotionally and financially in a calm way, and move on, you have mastered one of the most important lessons of all, namely the ability to view a loss as part of the business of trading. Trading is, after all, a business, and one like any other where we make and lose money.

In business, we sometimes make bad decisions, which result in a loss. We learn from the experience and move on, accepting this is part and parcel of risk. Perhaps we invested in some new product or process, perhaps we invested our time into a new project within the business, which ultimately did not produce the results we expected, or hoped for. Whatever the reasons, as long as we can look back and say we gave it our best efforts, then we move on, with the benefit of wisdom and experience. In trading, this is rarely the case. Many traders simply cannot accept a loss. A loss is seen as a personal failure, or a failure to read the market correctly. This emotion builds into anger and resentment and ultimately an urge to ‘get even’ with the market. Loss builds on loss and emotions run out of control. In a short space of time, trading based on logic, common sense and rules is replaced with gambling.

If you cannot learn how to accept a loss and move on to the next opportunity in a cool and philosophical way, then trading may not be for you. It’s not for everyone. This is the time to be honest with yourself, and is one of the many reasons you should never trade with money you cannot afford to lose. After all, losing money is one thing, losing someone else's (either a friend’s or the bank’s), is something very different.

This is what separates traders who struggle from those who succeed. Traders who make it, start by focusing on protecting their capital and deciding, in advance, how much they are prepared to risk, not how much they may make. And I hope I have made the point very clear.

Now let’s move on to consider money management in detail. How much should you risk, and how do you convert this into position sizes in the market? And there are two elements here. The first is on a position by position basis, and the second is in your overall trading account.

If we start with a simple example, which I hope will make the point as forcefully as possible and we’ll work in percentages as it's easier. Imagine you have just opened your forex account and deposited some funds, it doesn’t matter how much, and we’re ready to trade. We see an opportunity and decide to risk 50% of our trading capital on the trade. It ends as a loss, and we now only have half of our capital left. We decide to try again and not surprisingly we lose again, and have no capital left and our trading account is closed. We have lost 100% of our capital in two trades, which is not very sensible.

The question then is how much should we risk on each trading position? And my rule of thumb here is very simple. My suggestion and advice is try not to risk more than 1% of your trading capital on any one trade. Why?

Put simply, what this means is you can be wrong 100 times before your trading capital has gone. In the above example you were wrong twice, before arriving at this position. Using this money management rule, you can be wrong 100 times consecutively. More importantly, each loss is small, and if you remember back to the earlier examples, any loss has to be recovered by a larger percentage gain against the remaining capital. It is therefore imperative any losses are kept as small as possible.

The next point is this. Trading success is not simply a question of being right more times than you are wrong. It is far more complex, and those traders who succeed and produce consistent results over an extended period, will do so by keeping their losses very small. The profits on those winning trades will then outweigh the small losses. Suppose for example, a trader had eight losing trades and two winning trades. Is this trader profitable?

If the winning trades were $500 each and the losing trades were $50 each, the answer would be yes. But take the monetary aspect away for a moment, and in this example I presented a trader who lost eight times out of ten. Your immediate assumption would be, here was a trader who was losing and losing consistently. The opposite is in fact true. And this is what makes money management so important. If you allow one losing trade to become large, it will destroy that fine balance between profit and loss, which is not premised on the win/loss relationship at all, but on the monetary relationship between the winners and the losers.

Having suggested that 1% should be the maximum risk on each position, there is also an argument for increasing this figure, depending on the amount of your trading capital, and strangely this works inversely. In other words the smaller your account, then the larger the risk, but again this has to be capped and the guideline here is an absolute maximum of 5%. The question is, why have two levels, is one not enough?

The reason for this is simple. If you have a small trading account, the object of the trading exercise is to grow the account. In other words, capital growth. If you have a trading account with perhaps $500 or $1,000, a 1% rule would equate to $5 risk or $10 risk per trade, which in turn would not offer a ‘proportionate’ risk/return ratio. However, increase this to 5% and we now have a risk of $25 or $50 per trading position, and provided we stick to this money management rule, this gives us the opportunity to grow the account from a relatively small base. In other words, achieve capital growth.

As the account builds, the risk percentages are gradually reduced sliding from the 5% maximum, back to the 1% maximum and reflecting the change from capital growth, the starting position of our account, to income. In other words, once we have achieved capital growth, and the account has grown to $5,000 or $10,000, trading percentages are reduced to the 1% rules for future trading and the account is protected.

Again, this sounds slightly counter intuitive, but with a modest account size, it is very difficult to grow the account without taking on more risk initially. In many ways this reflects the approach entrepreneurs take in business. As they first start, the risks are high, but as the business becomes established, the risks taken are lowered, as there is more to lose. It’s all about judgement of risk. Losing a small amount of start up capital may be an acceptable risk for larger, longer term gains. Losing a large amount of capital is not an acceptable risk, and therefore the risk profile is reduced to a more acceptable level.

If we take a small account as an example, and suppose we have $500 of trading capital deciding to use the 5% rule as our maximum loss. This equates to $25 on each position in the market. Now we have to work backwards.

We know from examples earlier in the book, that a micro lot on the EUR/USD is equivalent to 10 cents per pip, a mini lot to $1 per pip, and a full lot to $10 per pip. Clearly a full size lot is not appropriate since this would be equivalent to a 2.5 pip move in the market before any loss were triggered which is not a practical proposition.

The mini lot makes more sense. Here we would have a 25 pip move before any loss, and equally a micro lot, would allow for a 250 pip move. The decision would therefore be between a single mini lot, or a multiple number of micro lots. Both would be equally viable, but let’s assume for simplicity, we decide to opt for one mini lot.

Any order management rule would then be triggered if the market moved against us by 25 pips, so provided our stop loss order (which I will cover in a later chapter) is at, or less than this from the price we enter the market, our money management rule will keep any loss to 5% of our trading capital, or less.

Alternatively, we could have entered a multiple number of micro lot contracts, at different levels, which would then have given us more flexibility in terms of managing and closing out positions as the market moved. However, provided the combined amount of capital at risk did not exceed the 5% limit, the money management rule remains intact.

There is one final element here which is this. The above examples assume the capital at risk remains the same throughout the life of the trade, and this is often not the case, as profits are often ‘locked in’ as we will see shortly. The % risk capital is the maximum at the open of any new position which is reduced as the trading position develops in the market, and again I cover this later.

Finally, just to round off this chapter, there is one other aspect that you will need to consider as your experience and trading account grows, and that’s the question of how much of your trading capital should be exposed to risk at any one time. My rule of thumb here is 10%. For example, if you have a modest trading account which is growing and perhaps has $1,000, then the maximum amount of capital exposed at any one time should never be more than $100, in other words, two trading positions using our 5% rule.

For larger trading accounts, such as $10,000 and above, the same rule applies and in this case would be $1,000, and using a 1% rule, ten trading positions would be the maximum. It's also important to remember, these rules are your maximum levels of risk. When you open a new position, and you are able to take less risk, that’s great and to be welcomed. As you will see shortly, we use the market to help us decide where to place our stop loss order, so if we can take a position and risk less, even better. The point is this. The rule is the maximum. If we can open a position with a lower financial risk, but with the same probability of success, then all well and good. Maximum is just that, the maximum. Aim for less if you can.

These are the very simple money management rules which will keep your trading capital safe. Your trading capital is the lifeblood of your business and needs to be protected and guarded jealously at all times. You do have to accept risk. After all, without risk you cannot profit. As I have already said in this book - there are only two risks in trading. The risk on the trade itself, and the monetary risk. The first part is the most difficult, and comes from analysing all the information from a technical, fundamental and relational perspective and making a decision based on the collective information. The second is comparatively straightforward, and is what we have covered in this chapter. Provided you follow the simple principles explained here, your trading capital will be protected and only exposed to quantifiable and manageable risk. In following these simple rules it will ensure your longer term survival in the market. And the longer you survive, the greater your chances of longer term success.