Why Protecting Trading Capital Comes First
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 the trading account from a rapid escalation of losses due to a moment of confusion, lack of symbiosis with the market, momentary inability to follow the 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 a trading system (whether automatic or discretionary) with an initial protective stop loss. This is an order that allows a trader to close a trade that is going badly at a loss, and it will only be executed when the market price is equal to the expected stop loss level. The stop loss order allows a trader 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 lost (as a percentage of the 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, traders must focus on these fundamental aspects. The stop loss can be considered akin to life insurance for the trader!
Money Management: Risk Management and Position Sizing
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 forex 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). For a trader with 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, that trader would immediately be swept away from the market, without even having a chance of a rematch.
Deciding How Much to Risk on Each Trade
Before starting to trade, you need to decide on some stakes.
Consider 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 the account in each operation, although this value tends to decrease for the less experienced and for novices (down to 2% or even 1%). For example, a trader who deposits 1000 euros into the account would have an initial risk of 5% per single trade equal to 50€. However, it could happen that a trader opens 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.
Calculating Position Size With a Real Example
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. Consider a trader who wants to risk 5% of the capital in each trade. With an initial account of 2000 euros, the risk per trade will be 100 euros. Suppose that trader finds a good trading opportunity on the EUR/USD exchange rate with a long entry at 1.44 and decides 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, the value of the pip needs to be worked out, but it is very simple. The pip value of a mini-lot is $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. This 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.
