In the past weeks several articles have discussed the concepts separately of Risk Management, Money Management and Account Management. Now it is time to tie them together. Although each topic will be approached individually at first, ultimately every trader implements these topics as one coherent plan. The goal of this article is to provide an example of how various elements interact with each other.
The risk and money management vary from trader to trader, from account to account, from strategy to strategy, from trade management to trade management and from trading psychology to trading psychology. As you can see many of the related Forex concepts are interconnected.
1) Trader perspective: this means that the risk management must be in sync with the risk profile of each individual trader or minimum acceptable level for a group of traders.
2) Account perspective: this means that each trader can have different risk profiles for various accounts. Regardless of the risk profile each trader can vary their level of risk per trading account.
3) Strategy perspective and trade management: the strategy will impact the level of drawdown and losing streaks which in turn will determine how much risk percentage can be taken within the risk profile. How a trade is managed and exited will determine the win versus loss percentage and the average win/loss ratio, thereby impacting the money management.
4) Trading psychology: any choices made in conjunction with a trader’s trading plan, risk and management, strategy, trade management, etc must be support by their own trading psychology. These must be in sync and in harmony so as to increase the probability of the trader following their rules.
Here is a very practical example:
Trader perspective: from our experience we can say that most traders consider themselves to have a “medium” risk profile. In most cases this type trader would probably want to keep the total drawdown below 20% (a rough estimate).
Account perspective: here a trader would want to split his accounts into a demo testing account plus a real live account (size depends on experience). The real live account itself could be split into numerous ones, which can be divided per strategy and/or time frame. For instance:
a) A new strategy is tested on demo account #1 (serious testing and rules implementation);
b) All other “fun” trades are tested on demo account #2 (it’s good to have a demo practice account which does not have any particular rules);
c) Tested strategy 1 is traded on real account #1 with a max drawdown of 10% in a month;
d) Tested strategy 2 is traded on real account #2 with a max drawdown of 7.5% in a month;
e) Strategy 1 is a intra-week swing trade and strategy 2 is an intra-day trade; therefore 75% of the trading capital is used for account #1 of which 33% is actually placed on the account of broker #1, whereas 25% of the trading capital is used for account #2 of which 50% is actually placed on the account of broker #2
f) With sufficient experience (!) a trader can opt for a tiny “high risk” account which means that the trader is willing to risk the total sum of this very small amount in order to gain quick account growth. This account could be traded with fixed lot sizes.
Strategy perspective: the risk per trade certainly depends on trading management and trading strategy characteristics and performance. Each strategy will create its own drawdown levels. With the drawdown (DD) levels (either historic and/or from testing) and the maximum accepted loss in mind we can calculate the risk percentage per trade: loss / DD = risk per trade. For this example let us assume that:
a) Strategy 1 has a DD of 10 units. From the account perspective we know that we are looking for a max drawdown of 10%, which means 10/10 = 1% risk per trade
b) Strategy 2 has a DD of 30 units. From the account perspective we know that we are looking for a max drawdown of 7.5%, which means 7.5/30 =0.25% risk per trade
There are other elements a trader can think of. Risk can be altered depending on the equity curve and closeness to maximum drawdown levels. Let’s review these parts:
1) Close to hitting the DD: when a trader is close to hitting their maximum monthly drawdown level they could opt to reduce their risk per trade. I like to call the zone which is within 1-20% of hitting the maximum drawdown level per month the “red zone”. In this red zone a trader is close to being forced to stop trading during that month despite the well calculated risk percentage level per trade. A trader can continue with usually trading and attempt to rebound which is best towards the end of the month. Or a trader can reduce risk per trade and allow for more opportunities during the month, which could make sense at earlier stages of a month. One reason why everyone wants to delay this risk reduction prior to hitting the max loss in a month is because strategies come in streaks and you do not want to “cap” the rebound potential. Ultimately it could be good to have a redzone instead of hitting one’s max loss in a month, but rather keep the red zone relatively on the high end of DD curve.
a) A trader can opt to risk more or less depending on the quality of opportunity and the . Obviously this is very discretionary element of trading and not recommended for most traders as it could have an adverse impact on drawdown and trading psychology.
b) A trader can opt to risk less during news event, speeches, high impact economic data, public holidays, other illiquid trading times and days.
c) Increasing risk on the trades after equity growth or decreasing risk on trades after a certain equity loss is a viable option, although it would have to fit within boundaries of the risk management. Also, a trader needs to be cautious of the psychological effect when decreasing/increasing risk and the usual presence of winning and losing streaks. Trading the equity curve of a strategy can be an interesting concept to work with though, but certainly provides extra complexity.
3) When a trade is still open but the stop loss has already been moved to profit, then a trader can designate this risk level of the trade as “off the table” and not count it towards to overall risk impact. This in turn allows a trader to use this risk freed risk for a new position / trade.
The main goal was to provide an example how risk management, money management, account management, trade management, strategy, and trading psychology all interact and influence each other. There are many angles that remain to be discussed but the length of the article would be too long.
What would you like to add? Let us know down below!
Thanks for sharing and Happy Trading!
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