that has come to be known as Zeno’s Paradox. I like to use it as an
example of how the methods that I’m going to show you ensure that you
don’t get wiped out.
Zeno presented the following situation: An archer shoots an arrow to
a target. At some point, the arrow reaches a halfway point. Okay, from that
halfway point to the target there is another halfway point. And from that
new halfway point to the target is a farther halfway point. How can the
arrow ever reach the target?
I can’t answer that paradox but I do know that we can use a similar
idea when designing a risk management scheme. We can make sure that
our equity never gets wiped out.
GOOD RISK MANAGEMENT:
FIXED FRACTIONAL
The core technique for risk management is called fixed fractional because
we risk a fixed fraction of our portfolio on every trade. If you always risk a
fixed percentage of your account, you will risk fewer dollars on each trade
as you lose money.
For example, let’s assume that you have $100,000 in your account and
you decide to risk 1 percent on each trade. Assume that you lose the maximum
on the first three trades. You will lose $1,000 on the first trade,
which is 1 percent of $100,000. You now have $99,000 in your account.
That means you can only risk $990 on the next trade. You are only allowed
to risk 1 percent of the total equity in your account. You only have $99,000
in your account after the first trade so 1 percent of $99,000 is $990. You
now lose on your second trade, leaving you with $98,010 in your account.
It should now be no surprise that you will only risk $980 on your next
trade.
Just like Zeno’s Paradox, there appears to be an infinite number of
times you can risk 1 percent. Of course, the real world is not so paradoxical.
You will eventually run your account down to a level where you cannot
put on any more trades. Nonetheless, the fact that every one of your losing
trades is smaller means that you can withstand a lot of pain before you are
effectively out of the game. This simple method can keep you in the game
for months or years. Hopefully, that amount of time will allow you to get
your trading act together and start to make some money.
HOW MANY CONTRACTS SHOULD
I PUT ON?
Suppose you have $100,000 in your trading account and you are risking 1
percent on each trade. You see a great trend analysis trade developing. It
turns out that you will have to risk $750 on the trade per contract. How
many contracts should you put on?
Basically, you take the risk that you are allowed for that currency pair
and divide the risk per contract into that risk. That gives you the number
of contracts that you are allowed.
The rule is that you can only risk 1 percent of your $100,000 on each
trade. That means that you can only put on one contract since you are
allowed to risk $1,000 and each contract is a risk of $750. Thus, risking
two contracts would be $1,500 and that would be too much risk for the
portfolio. So you only do one contract.
Don’t change the stop just because you want to do two contracts. You
should always pick the optimal stop point and then see how many contracts
you are allowed to buy, not the other way round!
The risk management rule is there to make sure you stick to the selfdiscipline
necessary to make money in the markets and not get blown out
by a few bad trades.
One of the potential problems with restricting your risk this way is that
you need to have a large bankroll. It is hard to trade forex using standard
contracts without risking at least $750 per contract. That means that you
must have $75,000 in your account to stick to the 1 percent rule. Many
traders do not have that much money in their accounts.
So you have two choices. First is to trade the mini- or even microcontracts
that are available from many brokers. This means that you will
be risking $75 on a mini-contract rather than $750 on a standard contract.
Note also that using a mini-contract allows you to take any intermediate
amount of risk up to your risk limit. The second choice is to earn more
money to deposit into your account.
HIGHLY CORRELATED POSITIONS
Based on the risk management rules, you cannot be trading highly correlated
pairs as if they were separate positions. For example, EUR/USD,
USD/CHF, and GBP/USD are highly correlated. You should apply the 1 percent
criterion to all of your positions in all of these pairs all the time.
For example, you are risking $750 on a position in USD/CHF and you
see an opportunity to enter a similar position in EUR/USD that would be a
risk of $800. Nope. You are not allowed to do that trade because it is too
highly correlated with the first position. You are more than doubling up
the risk.
What this means is that you should pick the best opportunity in each
group. You can’t put on all the channel breakout trades in all currencies at
the same time. You need to pick the best one of the bunch and pass on the
rest of the trades.
My way of doing this is to put in all the orders and wait for one to be
filled. I then cancel all the other similar orders. For example, I see a channel
breakout trade coming up in EUR/USD, USD/CHF, and GBP/USD. I’ll put
in all three orders. Once I’m filled in one of them, I cancel the orders in the
other two.
Basically, I’m saying that I take the strongest of the bunch and cancel
the rest. My reasoning is that the first one to break out is likely the best
trade of the three so that is the one I want to jump on.
Source: How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)
