Managing Risk in Forex Trading

The great traders, who manage to earn very high figures in this market, are aware that trading activity is full of victories and defeats and that in order to survive financially, it is necessary to optimize the profit/loss ratio to their advantage. Therefore, the first step to take is to have a plan to protect our account from a rapid escalation of losses due to a moment of confusion, lack of symbiosis with the market, momentary inability to follow our own trading plan, and so on. A negative period can happen to anyone, so it will be necessary to safeguard the account from unpleasant surprises. The simplest way to stop losses before they become too high is to equip your trading system (whether automatic or discretionary) with an initial protective stop loss. This is an order that allows us to close a trade that is going badly at a loss and will only be executed when the market price is equal to the expected stop loss level. The stop loss order allows us to decide ex ante the amount of risk for each individual trade, thus protecting the account from phases of accentuated drawdown, i.e. the money we lose (as a percentage of our account) in a prolonged streak of negative trades. The fundamental rule known to all professional traders is therefore to limit losses and keep them at minimal levels. Before even thinking about earning, we must focus on these fundamental aspects. The stop loss can be considered akin to life insurance for the trader! Everything related to capital management falls under the name of money management. The latter can be divided into two fundamental branches: risk management and position sizing. Optimal risk management and correct dosing of entry capital represent a trader's main weapons for success. Risk management is everything that concerns the management of the trade from the stop loss to the take profit. These concepts are highly correlated to each individual trader's risk tolerance level. There can't be an equal risk for everyone, so each trader will have to work to tailor their own suit. The level of risk tolerance depends on many factors, including the capital available in the account (working capital), age, financial soundness, and the objectives set for this activity (whether full-time or part-time). If we have an account of just 500 euros, it is impossible to think of risking between 200 and 300 euros in each single operation: with a couple of negative operations in a row we would immediately be swept away from the market, without even having a chance of rematch. Before starting to trade, you need to decide on some stakes. Let's start with the risk to be assumed in each trade, expressed as a percentage of the capital available in the account. The most correct solution would be to never risk more than 5% of your account in each operation, although this value tends to decrease for the less experienced and for novices (down to 2% or even 1%). So, if I have deposited 1000 euros into the account, my initial risk of 5% per single trade will be equal to 50€. However, it could happen that you open more positions simultaneously and this would risk increasing the overall risk level. It is therefore necessary to decide a maximum portfolio risk (for example, 150 euros with more than one open trade) or opt for a simpler solution suitable for less experienced traders: layering. This is the staggering of positions, i.e. no new trading operations are opened until the trade in the portfolio starts to move positively, guaranteeing at least a free-trade. This situation occurs when a trade starts to move strongly in the hoped direction, allowing the stop loss to be moved to the entry point (stop profit). This means that if prices start to move negatively until they reach the entry level, the operation will be closed at break-even. Risk management inevitably also embraces the management of the number of contracts to be used in each operation, i.e. the so-called position sizing. Let's assume we want to risk 5% of our capital in each trade. With an initial account of 2000 euros, the risk per trade will be 100 euros. We find a good trading opportunity on the EUR/USD exchange rate with a long entry at 1.44. We decide to place the initial stop loss at 1.4350. The risk is 50 pips, which in monetary terms is equivalent to 100/50 = 2 euros per pip. At this point we need to decipher the value of the pip, but it is very simple. A mini-lot is equivalent to $1, i.e. 0.69€ (1/1.44, based on the example). So, to determine the size of the position, just make the ratio of 2€/pip, i.e. 2/0.69 = 2.9. So, it means that to maintain the risk at the levels defined ex ante (100€ in the example), it will be necessary to use 3 mini-lots.