Risk management in fx trading
Successful forex traders will tell you that risk control is the most important aspect of trading.
It is the one technical tool that every trader has, that ensures that he will be able to trade again. Yet, it is often the last thing that newbie traders learn, mostly because they are so focused on making money, that they are not even interested in listening to the professionals.
A warning light for any would-be trader is if the reason for entering trading, is to make a living. Nothing exhausts a trading account as quickly as forced trades to try and reach a monetary target in a predetermined time.
A person who starts trading to make a living, is usually the easiest victims for the professionals to "smoke out" and divorce from their money. It is understandable that someone who needs to make an income every month to pay the bills, will not be very keen on missing trades because the risk/reward ratio is too small or a stop-loss could make their trade fail.
It often happens that a stop-loss is triggered, only for the price to reverse and move right into the initial profit zone.
If risk control is subject to other considerations, such as the need for a monthly income, it is only logical that the other considerations will influence the trading decisions. If the trader focuses on anything other than succesful trades, a consistent income remains a dream.
The market makes trades available to the skillful trader, but often it does not make anything available. It is then that the amateur trader tries to force a trade where none exists.
That is why it is wise to start trading long before you realise that you need more than what your salary can supply, long before you are retrenched and long before you retire.
The main aim of the "market" is not to provide you with grocery money or unlimited riches. Rather, its more focused on taking your money. The reason for that is that the "market" is nothing more than a collection of traders in one place (the market), who all want to buy groceries or become rich.
The newbie trader's biggest danger is however, not the traders who are dependant on the money. Your biggest threat are the consistent and responsible traders who have been profitable for a long time. It is they who depend on reckless traders who believe that forex trading is a get-rich-easy-and-quick system.
They are the 2% succesful traders, and while you neglect risk management, you remain one of the 98% unsuccessful traders who are the "milk cows" of the trading industry.
What are the elements of a risk management system?
- Value of all open positions. - open positions are trades-in-progress and it is advisable that you stick to a total exposure of 2% or less of the value of your trading account. An example would be if your money available for trading is $10 000.00. You should never be in a position where you could lose more than $200 - even if all you trades end in lossess, your total loss must never be more than the magical 2%. (Some traders use only 1.5%);
- Stop losses ( stop-loss orders) on all trades;
- The take-profit (TP) target of the trade;
- Responsible, well-prepared, well-informed, and well-researched trades;
- Plan the trade and trade the plan - do not make mid-trade changes to your trading plan;
- Get out of losers - close the trade when the reason you made the trade no longer exists;
- Ride winners - do not get out of a trade too soon because you become scared of losing your gains.
- Trade small - Trade small lots
Good to know
- The Gamblers Fallacy
- Confirmation bias
- Regresssion (reversion) to the mean
- Hasty generalization
- Conjunction fallacy
- Representativeness heuristic
- Sunk cost fallacy
- Why your trading strategy is still good after 10 losing trades
- Post hoc ergo propter hoc (after this, therefore, because of this)
- Black Swan Theory
BE ALERT: In South Africa, if you receive trading advice from someone who is not registered with the FSB, you are not be protected under the FAIS Act.