HOW TO MAKE SURE WE ARE IN GOOD RISK MANAGEMENT?

There was a famous Greek philosopher named Zeno. He developed something
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)

Safe Your Money and Kick Bad Risk Management Ass!!

Bad risk management can create stress that leads to bad trading. I have
seen many traders be both financially and psychologically debilitated by a
large loss or a string of losses. How many times have you seen people capitulate
after fighting the market by being long and a bear market relentlessly
kills their equity?

Once that bad risk management blows our mind, we are lost as traders.
We will start to do self-destructive things as “double up to catch up.” We
will look to punish a market to make up for our losses. Or we will hesitate
and not put on trades we should put on.

You can have the greatest method in the world but it will be a failure
if you don’t control your risk. All methods take losses. But what if those
losses cause you to be wiped out? You won’t have the money power to

come back to create all those glorious profits that the greatest method will
create.

Bad risk management is perhaps the most common reason for failure
as a forex trader. People tend to overtrade and put on bigger positions than
their equity can handle. They come into forex trading because of some hype
and think they can make a million dollars in the first month. They think that
all they have to do is follow the new system they bought and they can’t go
wrong. They put on a few trades that are way too big for their small equity
and the first few trades go south and they are financially crippled. They are
also likely mentally crippled and think that it is impossible for anyone to
make money in forex.

The hyped system may or may not be garbage. These traders will never
know, because they got blown out so quickly, that they never really gave
the system a real chance to succeed.

As you can see, psychology and risk management complement and support
each other. We always want to be cool, calm, and collected when we
trade and that won’t be possible if we are overtrading or have on positions
that are too large or if we have losses that are too large for our mind. We
need to remain rational at all times when we trade. The stakes are too high
to not do otherwise.

How do you feel when you take a large loss? I thought so. I don’t feel
good either. So it is important that we keep our losses to trivial levels. We
want to have losses so small that we can’t remember them the following
day. They should be so trivial that we hardly notice them and they certainly
don’t cause us any mental pain.

Capital preservation is more important than capital appreciation. I
have seen so many traders come to me for training after they have lost
50 percent of their money. Stop and think about this for a minute. They
need to now double their money just to get back to breakeven! That’s not
easy. They could get back to breakeven in just one trade if they were down
only a few percent.

And think about the psychology of the traders who have lost 50 percent
of their funds? Do you think they are approaching the market in a cool,
calm manner? Do you think their minds are blown? What chances do you
give them to double their money?

Risk management can take a good system and make it a bad one. Bad
risk management will destroy a good system.
Good risk management is more important than having a good system.
Bad risk management can turn a profitable system into an unprofitable system,
but not vice versa.

Let’s play a game. Let’s assume that you are going to flip a coin. Let’s
further assume that you have $100 and you are going to flip the coin 1,000
times. This is a totally fair game. All we are going to do is to change the
size of the bet.


First, let’s assume that we bet $10 on every flip of the coin. That’s
10 percent of our bankroll of $100. What are the chances that we will get
wiped out sometime during our 1,000 coin flips? Turns out that we have
over a 90 percent chance of getting wiped out. The reason is that all we
need is a net of 10 losing trades and we are wiped out. And there is over
a 90 percent chance that we will get that condition sometime during those
1,000 flips.

Now, let’s only bet $1 on each flip. What are the chances now that you
will get wiped out in the 1,000 flips? Turns out to be less than 5 percent
because now we need to get a net of 100 losing coin flips in the 1,000 flips
and the chances of that are very small.

One of the key factors to consider is that the return and risk are
asymmetrical. How can that be when the odds are 50–50 on each coin
flip? Shouldn’t I always end up with roughly $100 at the end of the
game? Nope!

Let’s simplify the game for purposes of demonstration. Let’s assume
that you are going to bet $100 on each coin flip. Unfortunately, you lose the
first flip. There. You’ve lost all your money. You don’t get to play the game
anymore.

Let’s start over. This time you win the first flip so you have $200 in your
account. But then you lose the next two flips. You’re wiped out again and
don’t get to play the game.

Do you see a pattern developing? If you do well, you still have a chance
of getting wiped out. But if you are wiped out, you never get another chance
of doing well. That is why the game is asymmetrical. Each flip is 50–50 but
getting wiped out means that you don’t get to play the game anymore.
That is the situation we have with trading. You may have a good system,
but getting wiped out means you don’t get to trade anymore to take
advantage of that good system. But making money in the beginning helps
you from getting wiped out but doesn’t completely eliminate the prospect.
As a result, we need to have proper risk management to make sure that
we can end up with enough of a chance to make money that the chance of
getting wiped out and not getting to play the game is eliminated.

Risk management is really another name for asset allocation. How we
allocate our precious resources is a major determinant of our eventual
profit.

Risk management determines how fast or slow we grow our portfolio.
Our portfolio will grow too slowly if we take too little risk, but we will
have little chance of being wiped out. On the other hand, our portfolio may
grow very quickly if we take big risks, but we run a high chance of getting
wiped out. Can we find the point where we have little risk of being
wiped out yet still have a great chance of growing profits in a dramatic
fashion?
Source: How to Make a Living Trading Foreign Exchange: A Guaranteed Income for Life (Wiley Trading)