Risk With A Forex Twist

Everything in life has a certain risk attached to it. Obviously some activities are less risky than others. Eating peanuts whilst sitting in your garden chair is very low risk; whereas driving a race car substantially increases risk and potential damage (to both materials and yourself). There are a lot of examples that fall between these two, or could even be considered less or more risky.

In life humans make a rough estimate decision whether the risk of an activity fits or exceeds their own risk tolerance. This tolerance will vary from person to person. Some humans take calculated risks, others avoid risk, whereas some over risk (thrill seekers).

Companies, investments and trading activities are also exposed to risk. Risk management is employed to control these risks.

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WILLINGNESS TO RISK

First of all, when engaging in Forex trading specifically, there has to be the willingness to risk. No matter what risk management is employed, a certain degree of account drawdown will always occur and this has to be acceptable for the trader (both from a cash flow and mental point of view) before gains can become realistic and achieved.

Simply put, Forex is a risky business. The willingness to risk plus having the confidence to trade (trading psychology / lack of fear) are the stepping stones to success.

Secondly, every Forex trader will have their own risk tolerance. For instance, some strategies could prove to be too risky for a trader’s trading psychology. It is important to know that level and limit so as to stay within those borders. A trader must find harmony between their risk tolerance, Forex strategies, and own trading psychology.

RISK TOLERANCE

With that said, once the risky nature of Forex trading is accepted and one’s own risk tolerance level has been understood, it is important to note that risk management is crucial for trading account survival and growth. Lots of emphasize is placed on risk management in the world of Forex trading – and that makes good sense.

The exact risk management parameters must depend on the risk tolerance and the trading goals of each trader. Ambitious goals will require more risk tolerance; and vice versa.

However, [tweetable alt=””]no matter what tolerance or goals a trader has, Forex must be treated as a business to achieve succes[/tweetable]s. Trading should never ever be a thrill seeking activity – even if your risk tolerance is very high. That is the threshold when trading potentially becomes gambling. Proper risk management and treatment of trading as business (trading plan, strategies, money management, trade management) are requirements to succeed. Here is the flow:

Willingness to risk –> level of risk tolerance –> amount of risk / trading capital –> risk management

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RISK MANAGEMENT

In this phase, traders must become strict and be equipped with an iron discipline. Risk management rules are non-negotiable. End of story.

That means whatever rules Forex traders determine, they must stick to them. Of course, after careful analysis and consideration, Forex traders can adjust their risk management parameters to more suitable levels. But when in the heat of the battle of trading, those rules are golden.

GOLDEN RULES

There are several golden rules of risk management in Forex trading.

The number 1 rule is: protect your trading capital. Without your trading capital, there is nothing left to trade. The business has gone bankrupt. Retail stores without stock/inventory can close their doors too. For Forex traders their capital is their stock. Forex traders must protect their risk capital so that they can keep their store open and trade another day. Most Forex traders will bust 1 or more accounts before achieving success. If it’s a small amount relatively to their total capital, then these traders create a 2nd chance for themselves.

How can a Forex trader protect their trading and risk capital? Here is a list:

1)      When using leverage, it is vital that traders use a Stop Loss. Without a Stop Loss the entire capital is at risk, the correct position sizing cannot be established, and the risk cannot be controlled and limited.

2)      For any given level of risk, the reward must justify it. This is called the risk-return tradeoff. Potential return rises with an increase in risk. Because Forex trading is a high risk activity, the trader needs to match that risk with a sufficient reward to justify the business. What can be considered sufficient depends on the risk tolerance and risk management of each trader. However as a rule of thumb, a trader wants to achieve more reward than their biggest drawdown.

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3)      Minimize the drawdown via Forex strategies. The lower the drawdown the better. Forex strategies support can achieve that goal and provide a roadmap for traders.

4)      Reduce drawdown by limiting the risk taken on any given trade.

5)      Employ lower levels of leverage. With lower leverages the risk of losing the trading capital decreases.

6)      Employ proper money management rules.

RISK AND DD

It is important to choose a risk percentage to minimize the drawdown (DD). A trader that does not have any risk levels in mind, could be risking 10% then 30%, then 20% on any given trade. That certainly would translate into a high probability of account blow-up (nothing left).

What should that risk percentage be? The information above might have given a rough guidance but let’s crunch some hard numbers.

A rule of thumb often used by Forex traders is not to risk more than 5% on any given trade. However, 5% is on the high side. Most traders would agree that a trader should trade less than 3% per trade. Commonly used risk percentages are 1 and 2% per trade. The risk percentage certainly will depend on what strategies are used and what experience level a trader has. And also the purpose of the account, which can vary from account to account.

a)      The less experience, the better it is to start with less risk, low risk or even no risk (demo).

b)      A long-term strategy usually less trading opportunities on average than a scalping strategy, which means that it can endure a higher risk percentage.

c)    The percentage of the risk capital of 1 particular account compared to the total trading capital, and percentage of the total trading capital compared to the trader’s total capital. The higher, the lower the DD should be, the less risk an account can entail.

Another way of calculating the desired risk management level is via this formula:

The accepted account loss divided by the largest drawdown (DD) equals risk percentage.

OR: Loss / DD = risk %.

Here is an example: Forex trader WXY has a strategy ABC that has had at max a drawdown of 30 units of risk. Trader WXY does not want tloss more than 40%  on the account. To avoid hitting the drawdown level, the trader WXY can risk 1.33% per trade (40/30) and not exceed the drawdown. If a trader wants to increase the likelihood of hitting the drawdown maximum, a trader can add a buffer to the largest drawdown to be more secure. In our example, a trader can add a third to the drawdown risk which makes it 40 units (30*1.33). In that case: 40/40= 1.0% per trade.

Hope that you enjoyed this take on risk? Do you have something that you want to add? Let us know down below!

Thanks for sharing this article and wish you Happy Trading and many Pips!

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  • Chris

    Hi Selva, that is great news 🙂 thank you! Happy to hear that.

  • Chris

    Hi Selva, sorry for the confusion 🙂 I have changed it in the body of the main text so what you see in the article is indeed the correct formula. The correct one is “The accepted account loss divided by the largest drawdown equals risk percentage.” When using the example in the article, when you have a drawdown of 30 losses, and each loss is 1.33%, then you will hit the max loss of 40% chosen beforehand.

  • Selva

    By the way, besides the equation, the article is very informative and I like the fact that you have written it with detailed explanation. Thank You!

  • Selva

    So what is the correct?

    “The accepted account loss divided by the largest drawdown equals risk percentage.” From your comment.

    or

    “The largest drawdown divided by the accepted account loss equals risk percentage.” This is still in the article above.

  • Chris

    This change has now been reflected in the article.

  • Chris

    Please note that there is a mistake in the article, it says: “Another way of calculating the ideal drawdown is via this formula: The accepted account loss divided by the largest drawdown equals risk percentage.”

    But it should read: “Another way of calculating the ideal risk percentage per trade is via this formula: The accepted account loss divided by the largest drawdown equals risk percentage.”

  • Chris

    Hi Osita! Thank you for your comments and feedback – those are always much appreciated as well. Glad to read that you appreciate this article!! 🙂 Thanks again and have a great trading week ahead!

  • Phoebe Ejimbe

    Great article, as always! Very informative and precise! I will definitely make adjustments to my trading plan and calculate my ideal drawdown using the “accepted account loss divided by the largest drawdown equals risk percentage” formula. Many thanks for sharing this knowledge!