Forex Trading and the Necessity of Risk Management
- Considerable focus is paid towards market analysis, but many lack the framework with which to properly employ that analysis.
- Trade, risk and money management are arguably more pertinent to the trader’s success than any specific analytical method(s). In this article, we explain why.
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Consistent and long-term profitable trading in global capital markets can be a difficult prospect, especially for the newer trader. Sure, the idea of buying and holding might sound simple, like anyone can do it: And from an individual trade perspective, it might not appear to take any special skills or background to be able to sit there while a trade moves in the money for you, practically doing all of the hard work itself. But the reality of the matter is that doing this numerous times over an extended period has a tendency to expose weaknesses, whether they be in psychology, execution or a simple lack of experience.
In this article, we’re going to delve into the realm of risk management in trading, specifically focusing on Forex markets. And we’re not just going to give you some tips and pointers while asking you to believe what we’re saying because we really know what we’re talking about. We’re going to accompany these points of emphasis with data based on real trades from actual traders that were looking to pull a profit out of the market, just as we’ve done on prior installments of our DailyFX Traits of Successful Traders research. The data contained in this article has been updated with trades placed with our parent company, IG Group, from January 1st, 2016 to December 31st, 2016; and the entire report is available as a free trading guide from DailyFX at the following link: DailyFX Traits of Successful Traders Research.
Why is Risk Management So Important?
Point blank – you’ll never know the future. That’s it. Your job as a trader is to forecast the future based on the imperfect information available to you in the present. Much of that information will be based on what’s happened in the past, and occasionally we can gleam an idea of potential scenarios based on upcoming economic events or data releases; but, by and large, we’re using the past in the attempt of forecasting the future.
Does the same thing always happen the same way? Of course not: Things change, matters evolve whether we like it or not, and this is what makes the prospect of analyzing markets so incredibly challenging and, to many long-term market participants, fun; because there is never a such thing as ‘perfection’ in a forecast as the world beneath market participants’ feet is constantly in some form of shift.
So, while your analysis is extremely important in getting the highest probability setups that you can find; it’s still just a probability with an opportunity for failure because no analytical method will be ‘right’ all the time. This is where risk management comes in, to mitigate the damage from when your setups or analysis don’t work out so that you have capital left to enjoy the run for when they do.
Winning Percentage is a Dangerous Focal Point
Many newer traders have a tendency to grade their performance on a trade-by-trade basis, looking at each individual setup as if it’s a war that must be won. This is simply not the case, and the reason is that the size of gains and losses are unequal and uneven. A trader could, theoretically, win only 10% of the time and still be profitable; provided that the one winner is worth more than 10x each individual loser. So, while this trader faces rejection 90% of the time, they’d still be profitable. They’ll probably feel pretty negative most of the time, especially at first, as facing rejection 90% of the time is something that most human beings are simply ill-equipped for. Most new traders would be unable to get to this point, as the rejection faced 90% of the time would likely deter them from continuing to trade long enough to learn that winning percentage isn’t the end-all be-all of trading in financial markets.
In our DailyFX Traits of Successful Traders data, we found that many major currency pairs saw traders winning well over half the time, and in some cases even over 60% of the time. So, for about three out of five trades, these traders probably walked away from the position feeling real good about themselves. Unfortunately, the net of their activities entailed a loss, despite the feel-good emotions that might have come from the higher proportion of wins.
Below, we’re looking at the winning percentage in seven of the world’s most common currency pairs. Notice how each is above the half-way point of 50%, with AUD/USD even nearing 66%, or almost two out of every three trades being closed profitably.
If you’re looking at the above graph, you might be getting excited just at the thought of it, with a greater than 50% chance of setting up a profitable trade. Not so fast, this is just a small portion of the picture. The more important part, and the reason that the majority of the traders represented in the above graph ended up losing is because of just how large losses were relative to the amount made on winners (amounts shown below are in pips).
The above chart should offset at least some of the excitement from the first graph, as this shows how much larger the average loss was than the average win in each of the pairs listed. Remember that near 66% win ratio in AUD/USD? Ya, that doesn’t matter as much when we see that the average loss is more than twice as large as the average win.
If your numbers line up exactly with the above data, and you’re seeing perfectly average performance; and you place 100 trades in EUR/USD, you’ll win 64 of them for an average gain of 13.1 pips. This means 838.4 pips were made on your winners; but, the other side of the ledger isn’t so pretty, as the 36 losses taken at an average of -26.6 pips given up on each would entail a loss of -957.6 pips. The net would be a loss of -119.2 pips, even with that 64% win ratio.
In Aussie – the numbers are even worse. With an average win ratio of 65.4%, the trader over a 100 trade sequence would win 65.4 at 14.3 pips each, for a total gain of 935.22 pips made. The losses, however, would more than eclipse this amount, as the 34.6 losers at a rate of -31.2 pips each would bring a loss of -1,079.52 pips. The net here, even with the stronger winning percentage, would be an even larger loss over 100 trades of -144.3 pips.
Clear evidence that the stronger winning percentage didn’t do these traders many favors, even if it did ‘feel good’ to win more often.
Why Does This Happen?
‘Sometimes you have to lose the battle to win the war.’
While it would be great to win all day every day at everything we do, life just doesn’t work that way. We only have so much focus or capital; resources are finite, and we have to intelligently deploy those resources into activities that are most beneficial for our goals. Otherwise, we run the risk of wasting the finite resources at our disposal on non-profitable activities (or trades) that should otherwise be abandoned. Moreover – we’ll often find ourselves in sub-optimal situations in which depletion of those finite resources will leave us short-handed for future endeavors. Just like losing a large chunk of your trading account on one bad ‘idea’ that doesn’t work out, and now you have to fight back from a smaller equity balance.
Where this is relevant in trading is those positions that you just can’t give up. Maybe you’ve been in a trend or perhaps you have a really good feeling about the way a certain data point will print – whatever it is, traders go into a position with a lot of hope and little planning. And then when the position doesn’t turn in their favor, they hold on; or, perhaps even worse, they ‘double down’ buy buying or selling more; under the presumption that the market is ‘wrong’ and that matters will correct.
This is toxic thinking, and there is a phrase for it: ‘Throwing good money after bad.’
The reason that many traders fall victim to this symptom is the fact that they’ll hold on to losers for too long while closing out winners too quickly. This likely comes from the mental negotiation that takes place when a position moves against the trader, causing them to drop their stop or move it lower in the hopes of ‘staying in the trade.’ And the reason that this is such a disastrously slippery slope is the concept of compounding. Once you take a loss, you have to gain an even larger return to make it back since you’re working from a smaller base. And if you’re taking larger and larger losses just to prove to yourself that you’re ‘right’, you’re draining equity even faster than you would have otherwise. If you start with £10,000 and you lose 20%, you now have to make back 25% just to get back to your original £10,000. And then – you’re just at break-even.
So, if you’re continuously taking larger losses just because you don’t want to get stopped out of this one individual trade, this is digging you and your account into a hole that is going to be increasingly difficult to escape from. On the table below, we’re looking at the return required to get back to your original starting point after a drawdown.
|drawdown||return required to ‘get back'|
Prepared by James Stanley
Once the trader has drawn down by 50%, they have to hit a homerun of a 100% return – just to get back to where they had started. And if the loss is larger, such as 80% or 90%, well, now they really have their work cut out for them because they have to earn 400 or 900%, respectively.
These types of return numbers are highly unlikely; so for the trader that is looking at consistent profitability, they’re going to want to try avoid the 80 or 90% drawdown in the first place because, frankly, it’s catastrophic for a trader’s equity line. And while this may sound overly-obvious, the fact of the matter is that many traders end up turning short-term trades into long-term positions in the ‘hope’ that prices will turn around in their favor. This is what creates those large, outsized losses that are difficult if not impossible to recover from.
How to Institute More Effective Risk Management in Your Trading
First and foremost, traders must realize that not every setup is going to work. So, when planning a trade, plan the level at which you’re comfortable admitting that this endeavor isn’t going to work out in the way you want and at what point you want to bail. This is where your stop goes.
Personally – I assume the very realistic possibility of failure on every trade setup that I take. Call it cynical, but I’ve found a much more comfortable existence in markets by expecting little and getting a lot of ‘positive surprises’ rather than expecting much and constantly getting let down. It makes it really difficult to be motivated to trade tomorrow or the next day if each market session is another beat-down of humility.
With stops set at comfortable levels, you can walk away from the trade without regret or the motivation to re-enter right after getting stopped out in hopes that it works out. Don’t let any one idea run your trading account for you. But once you find that comfortable area for your stop, calculate how much potential upside you might get out of the setup. If the possible profit is larger than your stop distance, is that a trade that you really want to place?
Risk Management Rule #1: Set a Stop When You Get into a Position
This might seem like common sense to many of you and for those who it is, I applaud you. Keeping open exposure without a stop is very similar to riding on a motorcycle on the highway without a helmet. Are you sure to perish? No, but the probabilities certainly aren’t on your side, and anyone embarking on such an endeavor should ask themselves if taking that risk is really worth the potential benefit that it might bring.
When you’re setting up a trade, think about the possible worst case scenarios. Assume that the trade won’t work, and then imagine what position you would want to be in. With a wide stop, that means that you’ll probably have to stare at an unrealized floating loss for a while before that stop comes into play or, worse, the stop gets hit and you have a gigantic loss in your trading account. This can be mentally defeating to open your trading platform every morning and having yesterday’s failures stare you directly in the face; whether it’s a floating loser of a position or a chunk of equity missing from a gigantic stop on a trade gone wrong. Try to preempt this by setting your initial stop to a level that you feel confidence in, so that if prices break beyond – you get out of the trade by letting your stop do its job of closing the position. You can always re-enter in the trade; and there is little reason to hang on with hope that matters might turn around.
So, assume the trade won’t work well – find the level that would prove to you that the idea probably isn’t going to work – and then set your stop to that level.
Risk Management Rule #2: Risk-Reward of One-to-One, at a Minimum
Traders can look to offset the Number One Mistake that Most Forex Traders Make by instituting a minimum risk-reward ratio of one-to-one. Meaning, if you’re going to risk £300 on this setup, ensure that you might be able to make at least £300 if you’re right to make taking the trade worthwhile. If you’re going to risk 65 pips, make sure that you can make at least 65 pips if the trade does, in fact, work out.
On the EUR/USD four-hour chart below, we’re looking at the current setup in the pair, with red lines set below prior support areas. Assuming a current price of 1.1415 for illustration purposes, the closest support point of 1.1375 would be a total stop distance of 40 pips, while the deeper level at 1.1310 would be 105 pips of risk. If I’m going to target the prior high, at 1.1490, which brings a total potential profit of 75 pips, I would be able to place a stop below the first point of support but not the second. Using the first point of support of 40 pips would offer a risk-reward of 1-to-1.85 (75/40 = 1.85). The deeper point of support would be a risk-reward of 1-to-.6818 (75/110 = .68181), which would be suboptimal; so if the trader really wanted to use that deeper point of support, they’re going to need a larger target to justify taking the trade.
Stop Selection in the Effort of Setting Effective Risk-Reward Ratios
Chart prepared by James Stanley
Risk Management Rule #3: Don’t Try to Do Too Much With Too Little
Leverage is probably one of the most difficult things that new traders have to learn to harness. Leverage amplifies everything: The old saying is that ‘leverage is a double-edged sword’, speaking to the fact that levering a trade amplifies both gains and losses to the trader’s account. But in reality, the painful side of that sword often cuts a lot deeper than any joy that it might bring, and traders need to approach leverage with a great deal of caution.
We discuss the concept of leverage in the FX market in the article, Leverage as Velocity. In many ways, learning to use leverage is like learning to drive a car; too much leverage too early is just like driving too fast with too little experience. You simply have fewer historical inferences from which to draw to know how to respond and react when the potential for catastrophe is staring you in the face.
The more leverage that is employed, the ‘faster’ a trade moves for or against the trader. A highly-leveraged trade using 20 or 25x leverage is like driving on the autobahn, where even a small error or a mistake can bring grave consequences. For traders that aren’t yet comfortable using leverage, or for those that are learning how to employ it, start with no leverage at all. If you have £5,000 in your account, limit your account sizes to 5k or below. As you gain comfort, you can slowly increase the amount of leverage employed to increase the ‘velocity’ of the trade, first starting with 2-to-1 leverage, or 10k position sizes for a £5,000 account. And if that works out well, you can go up to 3-to-1; slowly increasing your trade sizes as you get more comfortable with the prospect of managing a levered trade.
The key to keep in mind with leverage is that any trader’s career is not likely going to be made by just one or two ‘really good’ trades. This is about building a system, an approach that can be replicated month-in and month-out. And while all months probably won’t be winners, the losses faced during periods of drawdown can potentially be eclipsed by the gains made during ‘good months’ to allow the trader to have a positive net gain for the end of the year.
--- Written by James Stanley, Strategist for DailyFX.com
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