Forex Risk Management Secrets Explained

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A common question beginners and even experienced traders often ask brokerage professionals from time-to-time when approaching how to trade in a Forex is: “what should the potential risk be on a given trade and what should be the potential profit target?”

Unfortunately, there is no one optimum level that exists to best answer that question, since the way the values are determined should be entirely dependent on several other factors such as the following (which can each change over time):

 

  • the size of the specific trade relative to an account balance
  • the number of such trades that could be opened simultaneous
  • the frequency of how often trades are established
  • the expected duration of the trade (expected and worst case maximum time).
  • current and historical market volatility of the instruments traded
  • currency related  fundamental news (economic  & geo-political both domestically and world-wide)
  • historical and current prices and technical analysis and related price levels
  • the current  suitability of the investor for their given finances and situation
  • the traders’  overall tolerance for risk as well as their target investment goals
  • the style of trading used to enter and exit the market (method, system, signals,etc..)
  • the overall structure to the trading plan being followed (its layout, format, guidelines, etc…)
  • any rules and conditions that may exist that restrict the strategy specific functions or in specific circumstances.

Why Forex Risk Management Secrets are Important to Know

Because of all of these contingencies, and the above list is just an example and not meant to be exhaustive, the answer to what is the best amount of pips to risk versus target, or best percentage to risk versus target per trade or per day,etc… is absolutely relative to the other moving parts of the system such as described above and thus can often be unique for each person depending on their specific situation in time.

However, since the main theme in Forex trading is to make money, keeping losses to a minimum relative to profits is the key to making money, since the net result of the two added will return either a net-profit or net-loss.

This article will detail one crucial component that constitutes Forex risk management secrets, as traders can apply such an approach to understanding and tweaking the ratio of risk relative to reward for themselves, when managing their trading in order to better control the expected outcomes whether profitable or not, as well as control the odds or chances for their success over a large number of trades.

Comparing the size of Gains to the Size of Losses or vice-versa

The risk reward ratio will play a crucial role in determining your trading odds and as part of any risk-management applied to your account, and will be visible later on in the final trading results. For example, out of 1,000 trades, over a given time, if 800 of the trades had an average profit of $50.00 per trade, (800*50 = $40,000) but the other 200 trades had an average loss of $201.00 per trade (200* $201 * =$40,200), this would result in a net-loss of $200 on the account (+$40,000 minus $40,200 = (-$200)).

Risks Rewards The risk-reward ratio in the example was 4:1, or four units of risk (in this case $201) for every one unit of reward (or roughly $50). Another way to understand this ratio of the two, is using the Gain to Loss ratio (GTL) which divides the potential gain by the potential loss, which in this case would be $50/$201 =0.24, and is thus a negative GTL as it is under 1.00.

Just as if the number on the left side of the  risk/reward ratio equation is  greater than the number on the right side, it can be looked at as negative (i.e. 4:1 in the case above is negative). A neutral risk/reward or gain to loss ratio would be either 1:1 ( 5:5 or 10:10, etc…) or for the GTL it would always be about 1.00 for it to be neutral.

The best odds are normally achieved by using a positive ratio, however going too high – which means setting huge reward targets – while not risking enough-  could also be counter-productive, therefore a special balance is the key and is affected by a multitude of factors such as the time you are trading, what instruments are being traded, the size of the trade relative to your balance, how volatile the market is, and other aspects related to your strategy and the market, and as explained in Forex Blog’s post on How To Trade Forex Successfully.

How small details in fine tuning risk-management can have significant effects over time

In the above example the additional one dollar added in the $201 being risked is a seemingly small amount of money -relative to the overall amount (<1%), yet had a significant impact over a large number of trades, plus given the ratio of risk/reward and also the final results of how often the profit target was hit versus the risk-threshold, it caused a net-loss.

For this reason, fine tuning the numbers is a large component of helping to increase odds as part of the risk management process, and is essential for successful risk-management and thus successful trading.

Doing a thousand trades is a lot of work, yet the difference between losing $200 or making $20,000 could be a few small tweaks to the ratio of risk versus reward that is realized on each trade over the given time frame. The above extreme case is quite common on different amounts and ratios, and levels used, as after all the real key to making money from trading over time is to keep the average profit higher than the average loss, over a series of trades, regardless of the number and time frames involved.

Measuring Risk/Reward provides basis to forecast odds when planning

For example, all traders need to do in order to know what their risk is, would be to first figure out the pip value for a trade that is being planned, this can be done using a trade calculator such as the one offered by WorldWideMarkets in its AlphaTrader platform, then depending on the desired target profit,  and amount of potential risk to be taken, the values can be compared to each other using the above two ratios as an example and then a limit-order and stop-loss order can be applied to planned positions.

From here a trader can compute what the risk would be if ten such trades were opened at the same time, (i.e. stop-loss value* 10 = max potential stop risk and limit-value * 10 = max potential profit target), as well as calculate odds and how often levels can be reached in order to break-even, or hit a worst-case scenario loss or best-case scenario profit, and everything in between.

20150rr exp

Using the example here to the left, with a simple excel spread sheet, we cannot see the major difference that $1 has over the course of ten trades, but as shown in the above example,  the effect over 1,000 trades  amplified that difference into an amount that led to a net-loss.

However, seen in this simple example, is how often out of 10 trades the profit-target must be hit in order to generate a specific net results when compared to how often when the stop-loss level is reached how that loss affects the net-result.

For example, the negative ratio mentioned above (4:1 R/R or 0.25 GTL) shows that even if you hit the profit target half of the time,  (and hit the stop-loss threshold the other half of the time, from ten trades) there would still be a $1,000 loss.  With such an unfavorable ratio, a trader would need to be right 90% of the time just to barely earn $249, while if the trades lost 90% of the time the loss would be $1,759 nearly 7 times greater than the profit of $249 mentioned above.

If the ratio above was flipped, for example a Risk-Reward ratio of 1:4, and GTL of roughly 4.0, the odds would increase to provide a greater degree of flexibility or greater chance for a profit to result, as can be seen in the graphic below:

flipped50201rr exp

Final Thoughts on Applying Forex Risk Management Secrets

In closing its important for traders to realize that the realized risk/reward measured in historical performance will not always necessarily match the number of pips entered in the stop-loss and limit-values as its possible those levels were not reached and the trade closed prematurely.

While that difference between what was planned and what eventually was realized – itself could be the topic for another post, it’s still an important reminder that there can be a big difference between what you are  risking/targeting versus what you actually make/lose on any given trade.

However, when analyzing historical performance the trading results will naturally add up to reveal specific values on average, and if a trader can fine tune their trading, including the number of pips risked versus the number targeted per trade, on-average, while striving to keep the number that is eventually realized close in-line with the number planned, then the difference should be lessened and close to the values initially anticipated. Traders can practice applying the above measurements using a free Forex trading demo account and/or by opening  Forex trading live account when ready, and speak to a live customer support representative in order to apply Forex risk management secrets in real-time.

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