Risky Business: How to Skillfully Manage Risk in Your Curren

Joined : 23 Dec 2007 Posts : 241 Location : Nigeria

Say two different currency traders perform the exact same trades.

Over time, one loses the bulk of his trading account, while the other enjoys healthy profits. Now, how in the world is that possible when both traders are making the same trades?

The answer lies in risk management.

Both traders can easily be wrong on the same trades, but the first trader was "more wrong" than the other. He managed to be "more wrong" because he entered too big of a position for the size of his trading account. So his larger position helped him incur an even bigger loss. Thus, it took more time to make up that loss.

After all, if you lose 50% of your account, you don't just have to gain 50% back. No, from that point, you have to gain 100% just to get back to where you were before the loss.

The other trader made the same trade - just with a much smaller percentage of his account. Therefore, he didn't dig himself into the same hole the first trader did, even though he experienced the very same loss meaning that the second trader could make up that loss much faster than the first trader.

The Difference Between "Could" and "Should"
When novice traders call up their brokers, they often ask "How many lots can I trade?" But instead, they should be asking "How many lots SHOULD I trade?" In other words, look at what is prudent or practical to trade.

Many only focus on the need to "call the right direction." They forget about how much to "lay on the line" for that trade.

Many traders think it's perfectly acceptable to risk 20-30% per trade. However, the losses could be devastating. Others foolishly say they don't use a stop-loss at all. (Translation: They are willing to risk 100% of their account balance on each and every trade.)

Traders should only risk 1-5% of their account at any one time. That's what professional traders do. These skilled professionals aren't trying to knock it out of the park with any one trade. They are trying to win the game by hitting a bunch of singles.

How to Keep Your Risk Below 5%
So how do you determine if you're risking under 5% of your account with each trade? First, your "risk" is the amount of dollars you could lose on the trade between your entry price and your stop price. So you need to find out what 5% risk would add up to per lot. Once you know that, you know how many lots you "should" trade.

For instance, say I had a US$5,000 trading account and I only want to risk 5% of my account balance. That means that I could risk US$250 on any trade. If you're in a mini account (which most of you should be), then you'd be risking about a dollar a pip of movement per lot traded.

So if I could risk US$250, then I could trade one lot with a stop 250 pips from my entry. I could also trade two lots with a stop 125 pips away. If you're trying to decide on whether to trade a smaller number of lots and a wider stop OR more lots and a narrower stop...choose the former. It's always better to give your trade as much breathing room as possible - with a wider stop.

Ultimately, you want your stop-loss outside of the typical volatility for that pair. Note about how many pips a pair generally trades from high to low on any given day. This will tell you if you have a reasonable stop distance or not.

Well now you've been given a crash course in risk management. Believe it or not, this is far more important than calling the right direction in the trade. Don't get me wrong, you've got to eventually pick a few winning trades. But if you know how to properly manage the risk in your portfolio, then you don't need nearly as many as you might think.

For instance, some will ask how many trades you've won vs. how many you've lost. However, what if I won 10 trades of 10 pips each but then had 1 loss of 100 pips. I'm back where I started even though I won 10 of 11 trades.

Happy Trading!

Sean Hyman
Currency Director

"To win without risk is to triumph without glory."

- Pierre Corneille