Risk Management – Deciding When To Hold, And When To Fold

Forex risk management

There’s a proverb among old forex traders: If you put two newbies in front of the same trading screen and arm them with the same tools, and if each takes the opposite side of a given trade, both will probably lose money, regardless of the final direction of the price move.

Yet, if you put two highly-experienced traders into positions in opposite directions, very often both of them will win the trade or at least break even, in spite of their contradictory trading positions.

Why?

The difference between rookie traders and pros is risk management. In the trading game, successful risk management is the key to survival. Many beginning traders pay lip service to the idea of managing risk effectively, yet few have the discipline to follow through entirely, even with the power of mechanical trading systems.

Regardless of the exact forex trading strategy or system, loss-taking is a critical component for long-term success.

Any forex newbie can exit from winning trades, but it takes an experienced trader to slip out of losing trades relatively unscathed. In this article I’ve outlined several perspectives on risk management strategies used by successful forex traders across a wide range of markets.

Forex risk management

Most forex traders have a clear idea of their own investment objectives and tolerance for risk. And, most already know that appropriate risk management is crucial for success in any form of trading.

The best trading risk management means using a standard process to identify and analyze risks, then either accepting, mitigating, or rejecting them. For traders, it comes down to finding and assessing opportunities, then quickly acting on or declining those trades.

Basic risk management is two simple steps – Discovering and determining the risks within an investment, then responding to those risks in the best possible way to meet the investment objectives.

Some risks are considered intrinsic risks, or built into the system, while other types of risks are extrinsic in origin. In any event, forex traders have a variety of tools and metrics for assessing risks and setting parameter values. From that point onward, it’s up to the mechanical trading system to work its magic.

Mechanical risk management

Even when relying on mechanical systems, successful traders must be well disciplined and adhere to carefully-planned forex risk management and trade-exit strategies. That’s because people have a natural emotional aversion to taking trading losses, even when necessary.

Mechanical trading systems can help manage risks by better choosing and executing trades, and constantly monitoring positions. They add a layer of impartiality to lightning-fast analysis and trade execution. Yet, there is always room for human error in system design.

Speed plus reduced human oversight equals an increased possibility of trading loss. Mechanical risk management methods must be carefully vetted and tested before they’re implemented.

Most traders are closely focused on the “front end” of forex trading, that is, how to find a winning trade and enter a position at the right point. Other than basic stop-loss orders, few traders think carefully about how best to exit from the trade.

For the long-term survival of any trading system, whether manual or mechanical, the most important issue is how and when to exit from trades. Although less glamorous than the work of crafting a winning entry strategy, the task of building a successful risk management and exit strategy is crucial for success.

Lose your bad trades as soon as possible

Most traders are already aware of the mathematical difficulty of overcoming losses – As shown in the drawdown in Table 1 below, the more the trading-account equity is drawn down, the higher the percentage of subsequent gains required simply to break-even.

Table 1

Lose 25%, must regain 33% to break even
Lose 50%, must gain 100% to break even
Lose 75%, must gain 400% to break even
Lose 90%, must gain 1000% to break even

For example, after losing 50% of the trading account equity, the eventual winning trades would need to earn 100%, i.e. double the account size, simply to break even. Worse, at a 75% drawdown level, a trader would need to quadruple his or her account equity just to reach its original level.

Obviously, very few traders could achieve such a comeback. It’s far better to manage drawdowns by exiting each trade appropriately. Taking each loss at the optimal time allows the trader to stay in the game as long as possible, even after a long string of losing trades.

The runaway loss

Most traders have heard war stories about a single bad forex trade eating up days, months or even years of profits in one gulp. When a runaway loss occurs, it’s more likely the result of error in human judgment rather than from a glitch in the mechanical trading system.

Usually, catastrophic losses result from poor or non-existent risk management, failure to use “hard” stop-loss orders, and multiple trades in which the losses from the average losers are greater than the gains from the average winners.

A runaway loss shows lack of discipline. Instead of becoming enchanted by the dream of scoring “one big winner,” the more prudent strategy for trader survival is to focus on avoiding big losses.

The Golden Rule of Risk Management: Position risk limit

Ironclad stop-loss orders prevent runaway losses. According to the trader’s appetite for risk, the mechanical trading system can set risk limits according to account equity, position size and other parameters, as described later in this article.

Many forex traders advocate a “Golden Rule” of risk management based on position size or position risk limit. They recommend the at-risk account equity should never be more than 1% (conservative) or 2% (liberal) on any single trade position.

From a psychological standpoint, the trader can be indifferent to the outcome of any particular trade when only one or two percent of the account equity is at stake.

And, from a mathematical perspective, it’s important to point out that by risking only 1% to 2% per trade the system can lose repeatedly without approaching the drawdown levels shown in Table 1 above.

Regardless of the mechanical forex system being used, the trader should use only speculative capital. When asked by newbie traders how much money they should use to trade a given system, one well-experienced trader recommends choosing a funding amount which if entirely lost wouldn’t affect the newbie’s sleep at night.

Risk management styles

There are two general styles of successful risk management. Some managers refer to these opposite styles as either the “home run” approach or the “singles and doubles” approach.

On the one hand, a forex trader may choose to take frequent small losses and break-evens while working to harvest all profits from the relatively few big winning trades. Or, a trader may decide to seek many little gains and use infrequent but relatively large stop-losses with a system designed to accumulate the small profits and outweigh the losses.

The trading psychology is more important than the mechanical trading strategy itself. Taking many small losses tends to cause numerous painful twinges, interspersed with occasional moments of pure ecstasy.

In contrast, the “singles and doubles” risk management style offers plenty of minor joys, punctuated by some nasty psychological blows.

The best choice of trading style largely depends on the trader’s personality. A new trader will usually quickly discover which general style best fits his or her personality.

One of the major benefits of forex trading as compared with stock trading is that the forex marketplace easily accommodates both types of trading styles, using many different trading systems.

Since currency pairs trading is a spread-based marketplace, traders shouldn’t be too constrained by the number of round-trip transactions required by any given strategy.

For example, in the EUR-USD market, traders might find a 3-pip spread that’s the same as the cost of three one-hundredths (3/100) of one percent (1%) of an underlying position. This cost is generally uniform, in terms of percentage, regardless of whether the trader is dealing with one-million-unit lots or 100-unit lots of the same currency.

So, if a given trading strategy required 10,000-unit lots, the amount of the spread would be $3, yet for that same trade executed only using 100-unit lots, the spread would be a tiny $0.03.

This is in sharp contrast to the stock market, where the commission on 1000 shares or 100 shares of a stock valued at, say, $20 might be fixed at a total commission of $40.

That means the effective commission cost for the stock-market transaction might range between 0.2% to 2%, thus affecting the trader’s choice of risk management style.

Variability in commission percentages makes it difficult for small traders in the stock markets to scale into their positions because of these skewed commission costs. Yet, forex traders benefit from uniform pricing, so they can use either risk management style.

This freedom of risk management style has drawn many independent traders away from equity markets to forex markets.

4 basic types of stops

Another foundational choice to be made by forex traders based on personality and trading strategy is the type of stop to be used for risk management. There are four basic types of stops:

Equity stop

An equity stop is the simplest type of stop for mechanical trading systems. For any given trade entry, the system calculates a fixed percentage of the account equity, usually between 1% and 2%, as outlined earlier in this article.

For example, for a $10,000 forex account, the trader’s system could risk up to $200, or up to 200 points, on a single mini lot (of 10,000 units) of the EUR-USD currency pair, or up to 20 points on the standard lot with 100,000 units.

Aggressive traders sometimes consider 5% equity stops, that is, a position risk size of not more than 5% of the account equity. This limit is often considered the upper limit for prudent risk management.

Recalling the equity drawdown shown in Table 1 above, it can be seen that with a 5% equity stop 10 consecutive losing trades will cause a 50% drawdown in the trading account.

Also, it should be said that the biggest drawback of using an equity stop is it enforces an arbitrary exit point based on risk management alone, instead of exiting the market as a logical response to price movements.

Still, mechanical trading systems can thrive by using equity stops, especially when combined with other indicators to confirm trading signals.

Chart stop

Mechanical trading systems and expert advisors (EA) use a myriad of technical indicators to generate hundreds or thousands of potential stop levels. The best risk management methods combine the features of both equity stops and technical indicators to calculate chart stops.

One typical example of the chart stop is a swing high/swing low level. In the chart below, a $10,000 trading account with a mechanical system using a chart stop might sell one lot and risk 150 points, about 1.5% of the account’s equity.

 

Volatility stop

Mechanical trading systems often rely on more sophisticated logarithms to calculate risk parameters based on volatility instead of price movements alone. In any high-volatility marketplace, where prices show wide ranges, the trading system must adapt to the ambient volatility.

This helps the trader avoid being stopped out prematurely by market “noise.” And, the same holds true in low-volatility markets, where the system should constrict the risk parameters in order to avoid giving back profits before successfully exiting from positions.

One of the easiest ways to monitor volatility is by using Bollinger Bands, which rely on standard deviation calculations to measure variations in price. The two charts below illustrate high volatility and low volatility stop levels by using Bollinger Bands.

Bollinger band stops

Low volatility bollinger band stop

As seen in the first chart, a volatility stop lets the trading system employ a scale-in method in order to achieve better overall blended pricing and a quicker break-even level.

Of course, since total position risk shouldn’t be more than 2% of the equity in the trading account, the system choose smaller lot sizes to best fit the total position risk.

Margin stop

A margin stop is a form of risk management used by some cautious traders to reduce the risk and psychological pressure when beginning to trade an entire account by using a single new strategy or system. If used carefully, it can be effective in most markets.

Since forex markets operate twenty-four hours per day, it means that forex dealers could liquidate traders’ positions fairly quickly in case of margin calls. For this reason, forex customers are rarely in danger of generating a negative balance in their account, since computers automatically close out all positions.

The margin-stop risk management strategy is based on the trader’s total capital being divided into various allotments for each of one or more new or different trading strategies and systems.

For example, assume the trader is investing a total of $10,000 into forex trading, and he or she wishes to focus individually on trying 5 different trading systems and strategies in order to determine objectively which is the best “fit” for the trader.

So, the trader will open the forex account by wiring only $2000 from his or her bank account, assuming that each of the 5 receives the same funding proportion. If a forex broker offers leverage of 100-to-1, the $2000 deposit might allow the trading system to control two standard 100,000-unit lots.

Even better, depending on the trader’s risk tolerance and management, the system may trade using a 50,000-unit lot position. That might allow room for as much as 100 points.

As successive strategies are funded and launched exclusively, it’s easier to account for wins and losses due to individual approaches. It allows developers to refine their systems. And, traders enjoy more peace of mind by knowing that an unforeseen “blowup” won’t terminate their trading.

In any event, the primary purpose of the margin stop is to prevent a runaway loss from occurring during the launch of a new strategy or trading system. It also helps enforce discipline in risk and money management.

Know when to hold and when to fold

In conclusion, it can be said that trading success is based on surviving losing trades long enough to finally develop a consistently-winning system. Each forex trader should carefully consider his or her risk tolerance, and craft a risk management strategy to fit.

Mechanical trading systems make it easy to find good entry points, yet it’s just as important to have a sold risk management strategy, plus the tools to determine an exit point immediately after entering any position.

After all, taking the right loss at the right time is a necessary part of the game.

What are your thoughts about losses?

The post Risk Management – Deciding When To Hold, And When To Fold appeared first on MetaTrader Expert Advisor.

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