Risk management is the ability to contain your losses so you don’t lose your entire capital.
Here’s the thing;
If you have a £10,000 trading account, would you risk £5000 on each trade?
Absolutely not, because it only takes 2 losses in a row and you’ll lose everything.
If we take two Traders; Trader A and Trader B.
Trader A is an aggressive trader and they risk 25% of their account on each trade.
Trader B is a conservative trader and they risk 1% of their account on each trade.
Both adopt a trading strategy that wins 50% of the time with an average of 1:2 risk to reward.
Over the next 8 trades, the outcomes are Lose Lose Lose Lose Lose Win Win Win Win.
Here’s the outcome for Trader A:
-25% -25% – 25% – 25% = CAPITAL GONE
Here’s the outcome for Trader B:
-1% -1% -1% -1% +2% +2% +2% +2% = +4%
Clearly, you should never risk too much per trade and definitely never go all-in on a single trade. To further manage your risk, you can avoid trading during major economic events. The price pattern will also be clearer when there are no major economic events. You can check out when the major economic events will happen at Forex Factory.
Remember, you can have the best trading strategy in the world. But without proper risk management, you will still blow up your trading account. It’s not a question of if, but when.
So you're probably asking yourself, “How do I apply proper risk management"? The answer is position sizing.
A technique that determines how many units you should trade to achieve your desired level of risk.
But before you calculate your position size, you must know these 3 things:
Value per pip
The sterling value you’re risking on each trade
The distance of your stop loss
Then we need to calculate the amount of money that we want to risk on each trade.
I suggest risking not more than 1-3% of your account per trade. Why?
Because you don’t want a few losses to put you in a steep drawdown, or wipe out your trading account. And not forgetting, you need proper risk management to survive long enough for your edge to play out.
Here’s how to calculate your dollar risk per trade:
Let’s assume you have a £10,000 account.
You’re risking 1% of your capital on each trade.
Here’s the math: 1% of £10,000 = £100
This means you’ll not lose more than £100 per trade.
Remember, the risk of ruin is not linear. This means the more money you lose, the harder it is to recover back your losses.
Stop Losses will be covered in a video post that I'm putting together.
Lets assume that we have a balance of £1000 and we want to risk 3% on each trade.
We want to short the CAD/CHF market as the Forex Profit Accumulator has triggered for a short/sell.
We have a stop loss of 22 pips.
The amount that we would want to risk on this trade is £30 (3% of £1000).
If we assume that very crudely that 1 standard lot is equal to £10/pip.
Stop loss is equal to 22 pips.
The position size is therefore equal to 0.13 lots [£30 / (22* £10/pip)]
This means you can trade 0.13 lots on CAD/CHF with a stop loss of 22 pips; the maximum loss on this trade is £30 (which is 3% of your trading account).
There is a much easier way to do this and you can use a calculator which can be found at MyFXBook.
Hope this info helps.