Risk Management & Forex
In Forex trading, risk management can be the difference between the survival and sudden death of your account. Even if you have one of the most robust trading strategies, it’s still likely to fail without proper risk management.
So Why is Risk Management so Important?
As one of the most important concepts in trading, risk management is unusually difficult to put into practice for many traders. To put it bluntly, no matter how good a trading system is, you’ll never know the future. While your analysis for entering a Forex trade is important in getting the highest probability setups you can find, it’s still just a probability with an opportunity for failure, because as mentioned, you’ll never know the future. The market doesn’t care about your opinion, it does what it wants and more often than not, it does what it wants at most traders’ expense. This is where risk management comes into play. It’s nothing more than mitigating the damage that you’re exposed to when your setups don’t work out the way you expect them to.
What is Risk Management?
Two of the most important components in risk management are stop loss and position size.
As mentioned not every trade will be a winner and there’s no such thing as a 100% win rate which is why it’s important for traders to recognise when a trade isn’t working out. This is where the stop loss component comes into play. A stop loss is designed to liquidate a trading position at a predetermined point at which a trader decides his analysis is invalidated.
So why is it important? Well, capital preservation is just as important as making profitable trades because when a high probability setup arises, you need to make sure that you have the equity to be able to trade your setup.
When it comes to position sizing, many traders start out with a small account with the intention of growing it quickly. While everyone has their own level of tolerance for risk, it’s important that we don’t try to do too much with too little. What you’ll often find is that good traders tend to trade a smaller size that what you might expect. This allows them to do two very important things; keeping their mind right about whether their position is a winner or loser, in other words, not stressing because they’re trading too big a size. The second is that it allows them to stay patient and let the trade work itself out as opposed to letting their emotions take over.
Essentially, trade size is important because it makes it easier to swallow a losing trade.
Consider the table below to put into perspective the potential for damage to your account when losses and position sizes get out of hand, and just how hard it can be to recoup excessive losses when trading the Forex market.
|% Loss||% Gain Required to Breakeven|
You can see that once a trader has lost, or is in a drawdown of 50%, they have to make a profitable trade of 100% return just to get back to where they began and it just gets more and more difficult, the higher the drawdown.
I hope this article has given you a bit more insight into the importance of proper risk management when Trading Forex, and how it can make or break your trading account.
Have a great weekend, traders.
Source: Vantage FX Blog