Why It's So Important
Managing risk is key to every forex traders success. A trader who has generated substantial profits over his or her lifetime can lose it all in just one or two bad trades if proper risk management isn't employed. The 90-90-90 rule is a general rule of trading. It means 90% of new traders lose 90% in 90 days.
New traders can avoid becoming a part of this statistic by trading with a loss minimizing mindset. There are some simple yet essential risk management strategies that every forex trade must employ to stand a chance of not becoming a part of the 90-90-90 club.
Loss Limit Per Trade
Every trader should employ a loss-limit system whereby they limits losses to a fixed percentage of their trading account capital balance on a single trade. The best wat to facilitate a loss limit per trade system is for traders to use a stop loss.
Once the percentage risk per trade is determined, the forex trader uses position size to compute how far to set the stop loss away from the trade entry.
The 1% Rule
Traders stick to a method called the 1% risk rule. The 1% percent risk rule is never risking more than 1% of an account on a single trade. It assures minimal capital is lost when trading is not going well or market conditions are tough. If traders risk 1% of their current account balance on each trade they would need to lose 100 trades in a row to wipe out the account.
A trader that has an account of £10,000 would risk £100 per trade if using the 1% risk rule.
Following the 1% rule means traders can withstand a long string of losses. Assuming winners are bigger than losers, traders will find that their capital doesn't drop very quickly and rises consistently.
Stop Loss Placement
Stop-loss placement is often done using technical analysis on a price chart. A properly placed stop order acts as insurance against losing too much on a trade. When considering the best location to place a stop loss, traders must answer one question: At what price is their opinion wrong? There are several approaches to determining stop placement that can assist traders in finding the best stop loss location.
Fixed Stop Loss
One of the simplest ways to decide on the location of a stop loss is to use the fixed stop loss method, in which traders simply place a stop loss a certain number of pips from your entry price.
Below Support / Above Resistance Stop Loss
Support and resistance levels on a price chart are popular locations for traders to enter a trade. The logic follows that if traders are buying at a location where price is being supported, a safe location for their stop loss order should be below the area of support.
Calculating Position Size Per Trade ( In Lots )
to calculate position size per trade (let's say 1% of the trading account balance) traders must establish where their stop loss will be for the particular trade and measure the distance, in pips, between the stop loss and their entry price.
This is how many pips they have at risk. Based on this information, and the account risk limit (1%), the ideal position size can be calculated.
stop loss placement is usually based on a trading strategy. Traders should find the ideal location for the stop loss, and then calculate the position size.
Assume a $5,000 account and a risk limit of $50 on each trade (1% of account). A trader buys the GBP/USD at 1.3000 and places a stop loss at 1.3050. The risk on this trade is 50 pips.
The risk on the trade is 50 pips, and the 1% rule per trade risk is $50. It’s now time for a trader to determine the ideal position size.
They determine their position size based on account risk and trade risk. Since it’s possible to trade in different lots sizes, traders must be aware of which they are using.
A 1000 lot (micro) is worth $0.1 per pip movement, a 10,000 lot (mini) is worth $1, and a 100,000 lot (standard) is worth $10 per pip movement. This applies to all pairs where the USD is listed second (quote currency), for example the GBP/USD. If the USD is not listed second then these pip values will vary slightly.
If the price moves from 1.3000 to 1.3001 that is a pip movement, and will result in making $0.10, $1 or $10 based on the lot size taken.
Traders can use various combinations of these lot sizes, and trade multiple lots.
To find the exact position size, the following formula is used: [Account risk/(trade risk x pip value)] = position size in lots
Assuming the 50 pip stop in the GBP/USD, the position is: [$50/(50x$0.1)] = $50/$5 = 10 micro lots. The position size is in micro lots because the pip value used in the calculation was for a micro lot.
For the number of mini lots use $1 instead of $0.1 in the calculation, to get 1 mini lot [$50/(50x$1)] = $50/$5 = 1 mini lot.
The pips at risk will often vary from trade to trade. A traders' next trade may only have a 20 pip stop. They will use the same formula: [$50/(20x$1)] = $50/$20 = 2.5 mini lots, or 25 micro lots.
The image below shows an example, using a trade example on a chart.
As account capital fluctuates up and down, so will the dollar amount of the account risk. For example, if the account increases to $6,000, then the risk is adjusted to $60 on each trade. If the account value drops to $4,500, a trader should only risk $45 on each trade.
When the USD is listed second in a currency pair (quote currency), the pip value is fixed, as discussed above. However, when the USD is listed first (base currency), the pip value will vary based on the current price of the pair.
To find the pip value of a pair where the USD is listed base currency, divide the normal pip value (discussed above) by the price of the forex pair.
For example, to find the pip value of a USD/CHF micro lot, divide $0.10 by the current USD/CHF price. If the current rate is 0.9325, then the pip value is $0.10/0.9325 = $0.107.
For the USD/JPY the above procedure is followed, but then multiplied by 100 to get the proper pip value.
Here’s an example using a standard lot: $10/107.151 = $9.33; this how much each pip movement will cost if a trader has a one standard lot position.
A trading account drawdown is the difference between the balance of your trading account, and a net balance of your trading account. The net balance takes into account open trades that are in profit, or in a loss. If the account net balance is lower than the account balance, this is called drawdown.
For example, a trading account that starts with a balance of £10,000 that sees a drop down to £8,000 has seen a £2,000 or 20% drawdown. Drawdowns will also describe the likely survivability of a trading strategy over the long run.
A large drawdown puts a trader in a difficult position.
A trader that starts with a trading account of £10,000 and has a 50% (£5000) drawdown has a large task ahead of them. Because their account balance now stands at £5000, the trader must have a 100% return on £5000 to get their account balance back to £10,000 (breakeven).
Losing streaks in forex trading are inevitable, which means trading account drawdowns are inevitable. Having a predetermined stop loss on your trade and adhering to a loss limit per trade rule will limit the amount of a drawdown you will take so that an account can survive losing streaks.
Forex Broker Regulation
Traders must always consider the level of security a forex broker provides. A good forex broker must have is a high level of security. Traders should always check the credibility of a forex broker by ensuring they are regulated. There are regulatory agencies all over the world that separate the trustworthy from the fraudulent.
Below is a list of countries with their corresponding regulatory bodies:
United States - National Futures Association (NFA) and Commodity Futures Trading Commission (CFTC)
United Kingdom - Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA)
Australia - Australian Securities and Investment Commission (ASIC)
Switzerland - Swiss Federal Banking Commission (SFBC)
Germany - Bundesanstalt für Finanzdienstleistungsaufsicht (BaFIN)
France - Autorité des Marchés Financiers (AMF)
Canada - Autorité des Marchés Financiers (AMF)
Before depositing any capital with a forex broker, traders must make sure that the broker is a member of the regulatory bodies mentioned above.
Choosing Forex brokers with segregated accounts is a protective measure traders should choose to take. Segregated accounts mean clients’ funds are kept safe and separate from the broker’s own capital. It should be pointed out, however, that segregated accounts do not offer 100% protection. Traders have a right to receive compensation should a forex broker be declared bankrupt or forced into liquidation. However, the actual amount will depend on the rules and regulations in the country where the broker is registered.
What is most important is not that a broker offers segregated accounts, but how much a trader would be able to recover should anything go wrong.
The main reason for segregated accounts is to protect customer investments by preventing the company from using the funds in the course of their business. The company may want to use the customer funds for their own risk, operational expenses, and obligations. For example, the forex broker's company account became overdrawn. In the past, it was common for unscrupulous brokers to use their client’s money for their own gain, but it also put their clients money at risk of being lost. A segregated account is a measure of protection for a trader’s money and protects against dishonest and fraudulent behaviour.
Should a broker become bankrupt, segregated accounts also ensure that customer funds are easily identified. Some country regulations state that segregated accounts can’t be used to pay creditors, and should be returned to the customers.