Risk Management: Preserving your Capital

Trading leveraged financial instruments can be very risky without discipline and proper money management. In fact, a proper risk management system is the best tool you can have as a trader to be profitable in the long term.

In this lesson, we’ll teach you how to set up you money management parameters; how to calculate the risk exposure you are comfortable with before opening a trade and choosing bet size; why you must follow stop losses for a bad trading session and lock profits from a good one; and finally the concept of risk to reward ratio.

This is the most important lesson you will go through, it doesn´t matter if you are an excellent technician or if you have an enormous account to trade from, it all can go to dust very fast if you are not a disciplined trader.

What is money management and how to set up my risk exposure parameters?

The ultimate goal of a trader is to make a profit and grow his or hers account in the long term. In order to do so, we need to correctly manage our capital when taking a trade and know our comfort zone when it comes to risk exposure, i.e., bet size and stop loss level.

The following rules will help you to draw your own risk exposure parameters

1-     Never risk more than 5% of your trading capital in a single trade.

2-     Always look for a 1:2 risk to reward ratio or better

3-     Have stop losses when your are having a bad trading day to avoid revenge trading

4-     Lock in winning days by stop trading and prevent giving back your profits

Never risk more than 5% of your trading account

The % of exposure per trade varies from trader to trader; some feel comfortable taking a trade and risking 5% of their equity on a single position – but some can´t handle it and only risk 1% to 2% per trade; this is entirely up to you and you must decide the level of exposure you are comfortable with.

Let´s go through an example to illustrate why this is important. Let´s say you open a long spread bet on the EUR/USD and a short spread bet on the USD/CHF and are risking 5% on each one, price reverses and you get stopped out and are now down 9.75%. If you follow your money management rules of risking 5% of your equity and don’t let your emotions make you chase your losses you will be almost back to break even in 2 winning trades.

On the contrary if you don´t follow any rules and risk 20% on the first and 30% on the second you will be down 56% in just 2 trades, making a recovery very unlikely.

How to calculate your risk exposure using a stop loss

Calculating your risk exposure is very easy when spread betting and it´s the next step to take after choosing your comfort zone when talking about risk exposure.

Let´s assume that you are comfortable risking 3% of your capital per trade and you want to open a short spread bet on the GBP/USD at the current market price of 1.68509. Your spread betting firm quotes a spread of 16849.5 – 16852.9 and the market levels that invalidate your trading idea are 20 points away from the bid price. Remember that when placing a stop loss you are not choosing it from a set amount of points but from a level that the market gives you (more on that on the next lesson)

On this example, if your stop loss levels are 20 points away and you want to risk 3% on this position on a £5,000 account you need to calculate your bet size.

Bet Size = (equity x risk exposure) / stop loss

Bet Size = (5,000 x 3%) / 20

Bet Size = £7.5

This is the simple math you need to go through before taking a position and choosing your bet size.

Risk to reward ratio explained: Always look for a 1:2 RRR or better

This concept is not well applied in the trading community and sometimes overlooked by most beginner traders. Having a rock solid money management strategy is not only about keeping you losses short and knowing when to quit when you are wrong, but a big part of it is choosing great setups that yield a higher possible profit than the risk you would be taking should you enter the position: this is known as the risk to reward ratio.

In simple words, you need to look for setups that will give you at least a 1:2 RRR, meaning that if a setup to go long on the AUD/USD needs a 30 point stop loss, the possible profit needs to be at least of 60 points.

The idea behind this concept is that you will sometimes be wrong and lose trades. In fact, there´s the possibility that you will encounter bad streaks and lose trade after trade because of the irrationality of the markets; and by keeping your RRR to a 1:2 or better the winning trades will always overcome your losing ones thus helping you preserve your capital.

Locking in winner days and keep losers short

Last but not least, the psychological part of this lesson. It´s important to understand that even with the most air tight risk management system you will have bad days; when this happens you have a set of rules to lock yourself out of the markets.

Some traders choose to have a set number of losing trades before they wrap it up for the day, others choose to have a percentage base system, meaning that if they are down a 6% for the day, they shut down and come back the next day. Having a general stop loss system will prevent you from revenge trading: chasing your losses and making irrational trading decisions.

On the other side, when you are having a great day, it’s normal to slow things down and sometimes wrap up early; this will prevent you from overtrading your account and giving back the profits that you already banked.

Preserving your capital can be as simple as following these rules to create your own risk management system but it requires a lot of discipline to make it work in the long term.

Adam

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Adam is an experienced financial trader who writes about Forex trading, binary options, technical analysis and more.

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