Risk Management In Forex Trading Is Vital.
Risk management in Forex Trading means to manage the exposed risk in every trade you placed.
Why is it important?
It’s because risk management help you to know and calculate the suitable level of risk you need to take to achieve a certain amount of profit.
If you over risking your capital, it will have a high chance that you will wipe out your account.
Try to imagine that if you risk 100% of your capital for profiting 2 times of your capital.
The probability of profiting from this trade is 50%. Then that means you will have 50% of the chance loss all of your capital and 50% chance you will profit 200% from the market.
Is it worth it?
Of course no.
Because it is too risky!
The example of the trade above is just a gamble.
From the example, you will then know that the importance of risk management in order for you to profit from the market for a long period of time.
The simple thing that a trader needs to do in Risk Management is to calculate the affordable loss in every trade before entering the market.
That means you need to know what is the X amount of percentage from your capital will be gone if you LOSE in a trade.
Know Your Risk to Profit Ratio
What is Risk To Profit Ratio?
It is actually a calculation to know your ratio of your planned risk and your targeted profit.
E.g. if you risk 1% of your capital to earn 2%, then that means your risk to profit ratio is 1:2.
Another example: if you risk 2% of your capital to earn 6%, then your risk to profit ratio is 1:3.
That means your profit is 3 times of your risk.
Some of the traders will be using a fixed Risk to Profit Ratio in their every trade.
The Return Of Trade
Continue from the risk to profit ratio.
When we know our risk:profit ratio, then we can know that the number in profit is the return (ROI) of the trade expected.
E.g. if you have a 1:3 profit to risk ratio, that means your target of profit is 3R for the trade.
Another example is 1:1.5, it shows your Return (R) is 1.5R.
In the forex trading, traders will not compare the money they earned.
They will compare the “R” that their trading system can earn for them.
It is because the money earned doesn’t mean that you have a better trading system.
It may just means you have a bigger capital to trade or use a higher exposed risk to trade.
The higher the risk taken in a trade, the higher your “R” can be.
With the same risk to profit ratio of 1:3, when you risk 1%, your trading system can help you to win 3% if the price hit you profit taking level.
If you increase your risk in the new trade to 2% with the same trading system, that means you are now risking 2% to help you to earn a potential of 6%.
If you risk 3% then it’s 9%.
That is how the Return(R) play out in the ratio.
So in the trading world, the traders that earn a lot of money in trading may not mean that they are having a higher “R”, but a bigger capital.
REMEMBER THAT TAKING HIGH RISK IN A SINGLE TRADE IS A FORM OF SUICIDE. LOOK AT YOUR R AND NOT YOUR PERCENTAGE OF RETURN.
Know Your Win Rate
After you know your ratio and your R, the next thing you need to take in mind is to know what is your win rate from your trading strategy.
Your can have a win rate less than 50% but still profiting from the market.
So it’s more than half of the time you are having losing trades.
But you still can be profit from the market.
By having an R that is high enough to earn enough to cover the losses.
E.g. says your win rate is 40% and you trade average 10 trades per month.
You also have a risk to profit ratio of 1:2 and you risk 1% for each trade.
With the above information, we can do a small calculation.
40% of win rate from 10 trades means you will have 4 wins and 6 losses in one month.
When you win, you will earn a profit of 2%; when you lose, you will lose 1% of you capital.
The calculation for the profit is:
(4 X 2%) – (6 X 1%) = (8%) – (6%) = 2% in profit.
So in the end of the month, you will have estimated earning of 2% in profit.
From the above example, you then can know that how you can lose most of the time and still profit from the market.
As long as your “R” and your win rate can cooperate together, you can profit from the market. Some of the trader having high win rate but low “R”, and some having a higher “R” with a lower win rate.
But they may have the same percentage of monthly return.
Calculate Your Numbers
In ideal conditions, it is fantastic that we have high win rate with high “R”.
But, when we want to have more, we will have a higher chance to risk and lose more often.
With that says,
When you want to have a higher “R”, then that means you will have to sacrifice your win rate.
When you want to win more, then you will have less chances to get it.
So, you need to run your numbers, back-test and forward test your trading system to have the sweet spot of having good amount of “R” and higher win rate.
A trader can profit from the market with a low “R” but a higher win rate.
On the other hand, a trader who has a high “R” and a low win rate also can profit in the market.
By knowing your risk to profit ratio can let you optimize your trading system.
How do you optimize it?
When you have a higher profit ratio, then it is okay even if you have less than half of the time losing money in the market.
It means that your risk to profit ratio is related tightly with your win rate.
Everyone has their different set of system and method to profit from the market.
There is no correct or wrong pair of “R” and win rate.
As long as they can help a trader profit from the market, then it is a good system.
The difference is just which system is better than another.
It is a discovery journey and trial and error to find out your sweet spot for profiting in the market.
Because it is a lot about a trader’s personality and their trading styles.
Knowing How Probability Works
From the above win rate for your trading system, you can know that win RATE is a probability.
E.g. 50% win rate gives you half of the time you are winning.
Does it mean that you win alternatively when you trade?
Like: win, lose, win, lose,…
Nope, of course not.
For 50% win rate, it’s like flipping a coin.
You will not have tail or head alternately.
You maybe will consecutively having tail before you having a head.
This is the same as you trade.
You maybe will have consecutive losses until you have wins.
But when you continue flipping the coin or continue trade, the win and losses will be equal out.
So that is why risk management is important.
There will be possibility for Consecutive losses to appear when you have a win rate lower than 100%.
For a clearer explanation, look at the bottom diagram.
The diagram shows 100 boxes. 50 of them are in black color and 50 of them are in white color.
There are 50% of white and 50% of black boxes.
But when we look at the Section A in the above, there are 9 boxes.
So what is the percentage of black boxes over the nine boxes?
Next, for the Section B, there are 6 boxes.
What is the percentage of black boxes now?
Lastly, the Section C, it consist of 12 boxes.
What is the percentage of the black boxes?
If this compare to trading, we can roughly know how it is represented.
We will get wins and losses throughout the trading journey. But when the trades number increases, the result will show us the overall win rate we have.
Sometimes, we will have consecutive win.
And sometimes, we will have consecutive losses.
The probability is not dependent on just several trades outcomes.
When we know the concept of probability, we will then need to know the…
Chances Of Having Consecutive Losses
What is the chance of getting consecutive losses?
Look at the diagram below.
Source: Steve Burns Twitter
From the diagram above, you will know that even when you have a 95% win rate, the possibility of getting consecutive losses will still exist (12%).
If you have a 60% win rate. That’s mean 100% you will have consecutive of two losses in your 50 trades.
Other than that, consecutive of 4 losses is also normal since it has a 70% chance that the consecutive losses will happen.
Now, you know that consecutive losses is a normal condition.
Knowing the probability of losing is not to encourage traders, but to let the traders plan their trades and be ready mentally for what may happen during the trading journey.
Knowing the possibilities can also help you to ease out your emotions.
When you realize this, you will then no need to worry too much when consecutive losses happened.
When your Trading Psychology is in peace, you will boost your performance in trading.
Trading is a probability game.
When you understand it, you will be mentally prepared.
Protect your capital!
Risk management in Forex Trading is vitally important for a trader.
Without managing wisely, your capital is in danger.
From the post, you will remember risk management consists of two main elements.
Win Rate and Return (R) from trade.
By finding the balance of these two elements, all people can profit from the market.
All you need to do is find the sweet spot of these two elements where you don’t want to have too low win rate or too low return (R).
Because it might affect your performance on trading.
If a trader has a low win rate, he may feel exhausted to open a new trade, because of accepting losses again and again.
Lastly, if you want to be successful in trading, minimize your risk, take small losses and maximize your Return (R).
If you have this three elements, you will for sure profit from the market years after years.
Thanks for spending your precious time together.
Let us grow and learn together.