27 Risk Management

8/3/2019 27 Risk Management

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What is Risk Management?

This section is one of the most important sections you will ever read about trading.

Why is it important? Well, we are in the business of making money, and in order to makemoney we have to learn how to manage risk (potential losses).

Ironically, this is one of the most overlooked areas in trading. Many traders are just anxiousto get right into trading with no regard for their total account size.

They simply determine how much they can stomach to lose in a single trade and hit the"trade" button. There's a term for this type of investing....it's called...

GAMBLING!


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When you trade without money management rules, you are in fact gambling.You are not looking at the long term return on your investment. Instead you are only lookingfor that "jackpot".

Money management rules will not only protect you but they can make you very profitable inthe long run. If you don't believe us, and you think that "gambling" is the way to get rich,then consider this example:

People go to Las Vegas all the time to gamble their money in hopes of winning a big jackpot,and in fact, many people do win.

So how in the world are casinos still making money if many individuals are winningjackpots?

The answer is that while even though people win jackpots, in the long run, casinos are stillprofitable because they rake in more money from the people that don't win. That is where theterm "the house always wins" comes from.

The truth is that casinos are just very rich statisticians. They know that in the long run, theywill be the ones making the money--not the gamblers.

Even if Joe Schmoe wins $100,000 jackpot in a slot machine, the casinos know that there willbe hundreds of other gamblers who WON'T win that jackpot and the money will go rightback in their pockets.

This is a classic example of how statisticians make money over gamblers. Even though bothlose money, the statistician, or casino in this case, knows how to control its losses.Essentially, this is how money management works. If you learn how to control your losses,you will have a chance at being profitable.


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In the end, Forex trading is a numbers game, meaning you have to tilt every little factor inyour favor as much as you can. In casinos, the house edge is sometimes only 5% above thatof the player. But that 5% is the difference between being a winner and being a loser.

You want to be the rich statistician and NOT the gambler because, in the long run, you want

to "always be the winner."

So how do you become this rich statistician instead of a loser?

Capitalization

It takes money to make money. Everyone knows that, but how much does one need to getstarted in trading? The answer largely depends on how you are going to approach your newstart-up business.

First, consider how you are going to be educated. There are many different approaches in

learning how to trade: classes, mentors, on your own, or any combination of the three.

While there are many classes and mentors out there willing to teach forex trading, most willcharge a fee. The benefit of this route is that a well-taught class or great mentor cansignificantly shorten your learning curve and get you on your way to profitability in a muchshorter amount of time compared to doing everything yourself.

The downside is the upfront cost for these programs, which can range from a few hundred toa few thousand dollars, depending on which program you go with. For many of those new totrading, the resources (cash money) required to purchase these programs are not available.

For those of you unable or unwilling to pony up the cash for education, the good news is thatmost of the information you need to get started can be found for FREE on the internet


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through forums, brokers, articles and websites likeBabyPips.com. We should all thank AlGore for inventing the Internet. Without him, there would be no BabyPips.com.

As long as you are disciplined and laser-focused on learning the markets, your chances ofsuccess increase exponentially. You have to be a gung ho student. If not, you'll end up in the

poor house.

Second, is your approach to the markets going to require special tools such as news feeds orcharting software? As a technical trader, most of the charting packages that come with yourbroker's trading platform are sufficient (and some are actually quite good).

For those who need special indicators or better functionality, higher-end charting softwarecan start at around $100 per month.

Maybe you're a fundamental trader and you need the news the millisecond it is released, oreven before it happens (wouldn't that be nice!).

Well, instantaneous and accurate news feeds run from a few hundred to a few thousanddollars per month. Again, you can get a complimentary news feed from your broker, but forsome, that extra second or two can be the difference between a profitable or unprofitabletrade.

Finally, you need money/capital/funds to trade. Retail brokers offer minimum accountdeposits as low as $25, but that doesn't mean you should enter immediately! This is acapitalization mistake, which often leads to failure. Losses are part of the game, and you needto have enough capital to weather these losses.

So how much capital do you need? Let's be honest here, if you're consistent and you practiceproper money management techniques, then you can probably start off with $50k to $100k intrading capital.

It's common knowledge that most businesses fail due to undercapitalization, which isespecially true in the forex trading business.

So if you are unable to start with a large amount that you can afford to lose, be patient, saveup and learn to trade the right way until you are financially ready.

Don't Lose Your Shirt
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Here is a little illustration that will show you the difference between risking a smallpercentage of your capital compared to risking a higher percentage.

Trader Risks 2% vs. 10% on Each Trade

Trade

#

Total

Account

2% risk

on each

trade

Trade

#

Total

Account

10% risk

on each

trade

1 $20,000 $400 1 $20,000 $2,000

2 $19,600 $392 2 $18,000 $1,800

3 $19,208 $384 3 $16,200 $1,620

4 $18,824 $376 4 $14,580 $1,458

5 $18,447 $369 5 $13,122 $1,312

6 $18,078 $362 6 $11,810 $1,181

7 $17,717 $354 7 $10,629 $1,063

8 $17,363 $347 8 $9,566 $957

9 $17,015 $340 9 $8,609 $861

10 $16,675 $333 10 $7,748 $775

11 $16,341 $327 11 $6,974 $697

12 $16,015 $320 12 $6,276 $628

13 $15,694 $314 13 $5,649 $565

14 $15,380 $308 14 $5,084 $508

15 $15,073 $301 15 $4,575 $458

16 $14,771 $295 16 $4,118 $412

17 $14,476 $290 17 $3,706 $371

18 $14,186 $284 18 $3,335 $334

19 $13,903 $278 19 $3,002 $300


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You can see that there is a big difference between risking 2% of your account compared torisking 10% of your account on a single trade. If you happened to go through a losing streakand lost only 19 trades in a row, you would've went from starting with $20,000 to havingonly $3,002 left if you risked 10% on each trade. You would've lost over 85% of youraccount! If you risked only 2% you would've still had $13,903 which is only a 30% loss of

your total account.

Of course, the last thing we want to do is to lose 19 trades in a row, but even if you only lost5 trades in a row, look at the difference between risking 2% and 10%. If you risked 2% youwould still have $18,447. If you risked 10% you would only have $13,122. That's less thanwhat you would've had even if you lost all 19 trades and risked only 2% of your account!

The point of this illustration is that you want to setup your money management rules so thatwhen you do have a drawdown period, you will still have enough capital to stay in the game.

Can you imagine if you lost 85% of your account?!!

You would have to make 566% on what you are left with in order to get back to break even.

Trust us, you do NOT want to be in that position. You'd start looking a lot like Cyclopip. Doyou wanna look like Cyclopip? Didn't think so!

here is a chart that will illustrate what percentage you would have to make to breakeven ifyou were to lose a certain percentage of your account.

Loss of Capital % Required to get back to breakeven

10% 11%20% 25%

30% 43%

40% 67%

50% 100%

60% 150%

70% 233%

80% 400%

90% 900%

You can see that the more you lose, the harder it is to make it back to your original accountsize. This is all the more reason that you should do everything you can to PROTECT youraccount.

By now, we hope you have gotten it drilled in your head that you should only risk a smallpercentage of your account in each trade so that you can survive your losing streaks and alsoto avoid a large drawdown in your account. Remember, you want to be the casino... NOT thegambler!

Drawdown and Maximum Drawdown


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So we know that money management will make us money in the long run, but now we'd liketo show you the other side of things. What would happen if you didn't use money

management rules?

Consider this example:

Let's say you have a $100,000 and you lose $50,000. What percentage of your account haveyou lost?

The answer is 50%.

Simple enough.

This is what traders call a drawdown.

A drawdown is the reduction of one's capital after a series of losing trades. This is normallycalculated by getting the difference between a relative peak in equity capital minus a relativetrough. Traders normally note this down as a percentage of their trading account.


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Losing Streak

In trading, we are always looking for an edge. That is the whole reason why traders developsystems. A trading system that is 70% profitable sounds like a very good edge to have. But

just because your trading system is 70% profitable, does that mean for every 100 trades you

make, you will win 7 out of every 10?

Not necessarily! How do you know which 70 out of those 100 trades will be winners?

The answer is that you don't. You could lose the first 30 trades in a row and win theremaining 70. That would still give you a 70% profitable system, but you have to askyourself, "Would you still be in the game if you lost 30 trades in a row?"

This is why money management is so important. No matter what system you use, you willeventually have a losing streak. Even professional poker players who make their livingthrough poker go through horrible losing streaks, and yet they still end up profitable.


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The reason is that the good poker players practice money management because they knowthat they will not win every tournament they play. Instead, they only risk a small percentageof their total bankroll so that they can survive those losing streaks.

This is what you must do as a trader. Drawdowns are part of trading. The key to being a

successful trader is coming up with trading plan that enables you to withstand these periodsof large losses. And part of your trading plan is having risk management rules in place.

Only risk a small percentage of your "trading bankroll" so that you can survive your losingstreaks. Remember that if you practice strict money management rules, you will become thecasino and in the long run, "you will always win."

In the next section, we will illustrate what happens when you use proper money managementand when you don't.

Reward-to-Risk Ratio

Another way you can increase your chances of profitability is to trade when you have thepotential to make 3 times more than you are risking. If you give yourself a 3:1 reward-to-riskratio, you have a significantly greater chance of ending up profitable in the long run. Take a

look at this chart as an example:


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10 Trades Loss Win

1 $1,000

2 $3,000

3 $1,000

4 $3,000

5 $1,000

6 $3,000

7 $1,000

8 $3,000

9 $1,000

10 $3,000

Total $5,000 $15,000

In this example, you can see that even if you only won 50% of your trades, you would stillmake a profit of $10,000. Just remember that whenever you trade with a good risk to rewardratio, your chances of being profitable are much greater even if you have a lower winpercentage.

BUT...

And this is a big one, like Jennifer Lopez's behind... setting large reward-to-risk ratio comesat a price. On the very surface, the concept of putting a high reward-to-risk ratio sounds good,but think about how it applies in actual trade scenarios.

Let's say you are a scalper and you only wish to risk 3 pips. Using a 3:1 reward to risk ratio,this means you need to get 9 pips. Right off the bat, the odds are against you because youhave to pay the spread.

If your broker offered a 2 pip spread on EUR/USD, you'll have to gain 11 pips instead,forcing you to take a difficult 4:1 reward to risk ratio. Considering the exchange rate ofEUR/USD could move 3 pips up and down within a few seconds, you would be stopped outfaster than you can say "Uncle!"

If you were to reduce your position size, then you could widen your stop to maintain yourdesired reward/risk ratio. Now, if you increased the pips you wanted to risk to 50, you wouldneed to gain 153 pips. By doing this, you are able to bring your reward-to-risk ratiosomewhere nearer to your desired 3:1. Not so bad anymore, right?

In the real world, reward-to-risk ratios aren't set in stone. They must be adjusted dependingon the time frame, market environment, and your entry/exit points. A position trade couldhave a reward-to-risk ratio as high as 10:1 while a scalper could go for as little as 0.7:1.

If you want a real world example of traders trying to maximize reward-to-risk ratios, youshould check out Pipcrawler's Pick of the Day blog and Cyclopip's Weekly Winner.

Pipcrawler normally takes trade setups that have at least 2:1 ratios, while Cyclopip pinpointsthe best setups from the previous week that would have maximized his profits.


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Summary: Risk Management

Be the casino, not the gambler!

Remember, casinos are just very rich statisticians!

It takes money to make money. Everyone knows that, but how much does one need to getstarted in trading? The answer largely depends on how you are going to approach your newtrading business. It varies person to person.

Drawdowns are a reality and WILL happen to you at some point.

The more you lose, the harder it is to make it back to your original account size. This is allthe more reason that you should do everything you can to protect your account.

We hope that you have gotten it drilled in your head that you should only risk a smallpercentage of your account in each trade so that you can survive your losing streaks and alsoto avoid a large drawdown in your account.

The less you risk in a trade, the less your maximum drawdown will be. The more you lose inyour account, the harder it is to make it back to breakeven.

This means you should only trade only a small percentage of your account. The smaller thebetter.

Less is more.


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2% or less is recommended.

Although it is desirable to trade with a high reward to risk ratio, it comes with a drawback. Inthe real world, reward-to-risk ratio's aren't set in stone.

They must be adjusted depending on the time frame, market environment, and your

entry/exit points.

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27 Risk Management