Risk Management- Overcoming Fear of Account Blowout

Age : 31 Joined : 08 Jan 2008 Posts : 9 Location : U.S.A

If you were a trapeze artist, would you make sure you had
a net under you so that your career as a trapeze artist didn't
come to a crashing halt?

Well, many investors and traders do just that....no net.

It's like they prefer the thrill of losing rather than the thrill
of winning. A financial death wish. No plan. Not net.

There is a huge industry marketing services and software to
help an investor attempt to make winning trades. There are
books and gurus ready to teach you systems and "sure-fire"
ways to get rich just by choosing the right stock, fund or
commodity at the right time.

But rarely is it mentioned that money management is a key
aspect in becoming a successful investor.

As a matter of fact, proper money management is probably
more important than a good trading system.

Investing and trading is a matter of choosing high probability
wining trades. But probability is just that, probability.

Even obvious winners can turn on investors and take a bite
out of the account balance. It's a fact: losing trades will
happen. As a matter of fact, the key to long term success
as an investor-trader is staying in the game; being invested.

The way to have staying power is to have a money
management system, which helps to conserve your trading
capital and provides rules profit taking, loss prevention and
when to take a pause when things are going against you.

Let's take a look at perhaps the single most important fact
that drives investors out of the market with their tails between
their legs.

% Drawdown % gain required to recoup losses

10 11.11
20 25.00
30 42.85
40 66.66
50 100
60 150
70 233
80 400
90 900
100 busted

As you can see, once losses get below about 40%, it
becomes a challenging task just to get back to
breakeven.

When you eat into half of your trading account capital
you have to have a 100% return just to get back to the
beginning balance.

Professional investors and traders realize this fact and
set limits on how much the trading account balance
can be "drawn down".

For example, a trading plan would include a "drawdown
limit" that if hit would trigger the trader to stop trading
and review the trading system or just step back and
re-evaluate what is happening.

Typically, 20% to 30% is set as a drawdown limit on
trading accounts.

The money management plan also helps eliminate
catastrophic loses by placing a limit on the amount
available for each trade.

Remember, investing and trading is a game of probability.

The longer you can stay in the game and be exposed to
high probability trades, the better your long term success
as probability will-over time-work in your favor.

To do this, you need to conserve capital.

To help achieve this, many traders will limit the maximum
amount allowed for each trade to 1%-2% of the account
balance. Again, it's not about hitting home runs but about
hitting for average over time.

If you trade conservative amounts of your trading capital
and have strict rules on when to stop trading, you can stay
in the game much longer and have a better chance of
winning more trades than you lose.

Indeed, successful trading is a long term proposition of
discipline and patience. With a well defined plan of action,
fear will disappear as emotional reaction is replaced by
pre-planned action.

Joined : 10 Mar 2008 Posts : 9 Location : USA

My best strategy for controlling risks is setting stop/loss orders closer to the opening price than limit orders.

Age : 36 Joined : 14 Jan 2008 Posts : 4 Location : nigeria

@follet
how do mean'setting ur stop loss orders closer to the opening price than limit orders''?does it make any difference if stop/loss orders are at d opening or closing price?and why is limit order not better when setting stop oders.sori for too much questions

hi all, I came about this money mgt strategy recently
The advantage of this strategy is that you already know your max loss and max profit potential before you enter the trade, which allows you to choose your risk reward level.
The first step is to figure out the maximum number of lots you can trade on your account (the max deal). To find the max deal, simply multiply the total dollar amount of your account by 100. (EX: a $1,000 account has a max deal of $100,000 or 1 standard lot). This would not even be enough to trade this strategy since you need at least 1 lot per side or 2 lots total.

Let’s say you start with a $10,000 standard lot (100K) account. You will be able to deal $1,000,000 worth of currency (1 standard lot = $100,000) so you can trade 10 lots at a maximum. (1,000,000/100,000)

Since you are placing 2 trades at the same time in this strategy, the maximum number of lots you could trade is 5 on each side of the market, for a total of 10 lots.

The max loss is 50 pips (25 stop loss on both sides) which equals a

$1,250 loss per side of the trade (5 lots x $10 per pip x 25 pip stop) or a total of $2,500.

If you decided to take the max risk on this trade you could lose $2,500 or 25% of your total account value ($10,000 - $2,500 = $7,500).

Profit would be $1000 or 10%. This offers you the highest risk/reward ratio. However, be careful with trading the maximum leverage because if you do lose the 25%, you will only be able to trade on $7,500 next time (max deal of $750,000 or 7 lots total).

So, if you hit three trades for the month at the max leverage, you would make $3,000 ($1,000 max profit x 3 trades) for a monthly gain of $3,000 or 30% ($3,000/$10,000).

This strategy will also work on a mini account. A mini account trades the same way a standard (100K) account does but it uses 1/10 th the contract size. So, basically, the dollar amounts would be divided by 10.

This is what I mean by “choose your own risk/reward”. Since you

know your max loss and max gain before you place the trade, you can figure out how much you want to risk and how much you can potentially make. For some people, the high probability of making 10% on each trade is worth risking 25% per trade. Some people would be more comfortable with risking only 5% in order to make 2% on each trade. You can modify the risk/reward level to suit your own personal tolerances. See the examples below.

Risk/Reward Scenarios

10/25 PLAN

$10,000 standard (100K) account (10% profit, 25% risk) Max Deal: 1,000,000 (10 lots)

Max Gain: $1,000 (5 lots per side x 20 pip profit x $10 per pip)

Max Loss: $2,500 (5 lots per side x 50 pip loss x $10 per pip)

8/20 PLAN

$10,000 standard (100K) account (8% profit, 20% risk)

Max Deal: 800,000 (8 lots)

Max Gain: $800 (4 lots per side x 20 pips profit x $10 per pip)

Max Loss: $2,000 (4 lots per side x 50 pip loss x $10 per pip)

6/15 PLAN

$10,000 standard (100K) account (6% profit, 15% risk)

Max Deal: 600,000 (6 lots)

Max Gain: $600 (3 lots per side x 20 pips profit x $10 per pip)

Max Loss: $1,500 (3 lots per side x 50 pip loss x $10 per pip)

4/10 PLAN

$10,000 standard (100K) account (4% profit, 10% risk) Max Deal: 400,000 (4 lots)

Max Gain: $400 (2 lots per side x 20 pips profit x $10 per pip)

Max Loss: $1000 (2 lots per side x 50 pip loss x $10 per pip)

2/5 PLAN

$10,000 standard (100K) account (2% profit, 5% risk)

Max Deal: 200,000 (2 lots)

Max Gain: $200 (1 lots per side x 20 pips profit x $10 per pip)

Max Loss: $500 (1 lots per side x 50 pip loss x $10 per pip)

To figure out which risk/reward scenario you want to apply to the total capital you have in your account, calculate:

Total Account Value X 100 / $100,000 = Total Number of Lots or Max Deal

Max Deal x 100% /2 = 10/25 Plan
Max Deal x 80%/2 = 8/20 Plan
Max Deal x 60%/2 = 6/15 Plan
Max Deal x 40%/2 = 4/10 Plan
Max Deal x 20%/2 = 2/5 Plan

Example:

You deposit $18,000:

$18,000 x 100/$100,000 = 18 Total Lots

18 Lots x 100% / 2 = 9 lots per side (10/25 Plan)

18 Lots x 80% / 2 = 7 lots per side (8/20 Plan)

18 Lots x 60% / 2 = 5 lots per side (6/15 Plan)

18 Lots x 40% / 2 = 3/4 lots per side (4/10 Plan)

18 Lots x 20% / 2 = 2 lots per side (2/5 Plan)

Of course, depending on the capital you will not always have exact amounts, but you can round up or down accordingly.

For Mini accounts, divide everything by 10.

last time,I showed you some basic money management tactics to adjust the maximum risk to your personal tolerance level,so lets go to how we can use adjusted stop loss in our risk management.

Adjusted Stop Loss

We can reduce risk further by setting an adjusted stop loss once the

positive leg of the trade has reached a certain point. We have set this point at 28 pips. So, on the way toward the profit target of 45 pips, if at any point, the price goes +28, we move the stop loss from -25 to our entry point. This makes the max loss on that side 0 while the max loss on the losing side remains at -25 for a total loss of 25 pips instead of 50 pips, thus reducing our risk by half.

Example:

Short EUR/USD @ 1.2876
Long EUR/USD @ 1.2876

The EUR/USD short goes against us and stops out at a loss of -25 pips. The long goes in our favor and is +32 pips (> 28 Pips), our stop loss automatically moves from 1.2851 (-25 pips) to 1.2876 (entry price).

If the price of the EUR/USD continues to go in our favor on the long position and hits our

profit target of +45 then we will have a net profit of +20 pips. If price reverses and goes back down to 1.2876, then we will be stopped out at even on the long position and have a total net loss of -25 pips (from the stopped out EUR/USD short) and thus half of the normal max loss.

The disadvantage to this strategy is that if price reverses temporarily and stops us out at the adjusted stop loss (entry price) and then eventually goes in our favor once again and ends up hitting the profit target of +45, then we missed an opportunity to take our net profit of +20.

However, especially for those averse to risk, we suggest using the

adjusted stop loss when trading this strategy. Based on percentages, the number of times that price will stop out at the adjusted stop loss and then continue to our profit target is very low, which makes it worth avoiding the 50 pip loss.

Risk/Reward Scenarios w/Adjusted Stop Loss Applied

10/25 PLAN

$10,000 standard (100K) account (10% profit, 12.5% risk) Max Deal: 1,000,000 (10 lots)

Max Gain: $1,000 (5 lots per side x 20 pip profit x $10 per pip)

Max Loss: $1,250 (5 lots per side x 25 pip loss x $10 per pip)

8/20 PLAN

$10,000 standard (100K) account (8% profit, 10% risk)

Max Deal: 800,000 (8 lots)

Max Gain: $800 (4 lots per side x 20 pips profit x $10 per pip)

Max Loss: $1,000 (4 lots per side x 25 pip loss x $10 per pip)

6/15 PLAN

$10,000 standard (100K) account (6% profit, 7.5% risk)

Max Deal: 600,000 (6 lots)

Max Gain: $600 (3 lots per side x 20 pips profit x $10 per pip)

Max Loss: $750 (3 lots per side x 25 pip loss x $10 per pip)

4/10 PLAN

$10,000 standard (100K) account (4% profit, 5% risk)

Max Deal: 400,000 (4 lots)

Max Gain: $400 (2 lots per side x 20 pips profit x $10 per pip)

Max Loss: $500 (2 lots per side x 25 pip loss x $10 per pip)

2/5 PLAN

$10,000 standard (100K) account (2% profit, 2.5% risk)

Max Deal: 200,000 (2 lots)

Max Gain: $200 (1 lots per side x 20 pips profit x $10 per pip)

Max Loss: $250 (1 lots per side x 25 pip loss x $10 per pip)

As you can see, the adjusted stop loss brings the risk significantly closer in line with the profit potential.