If I could use only one trading rule it would be this: always calculate and assess the risk of a trade before getting into it. How much risk one is willing to take on should be part of the thought that goes into a business plan.
People define risk differently. Some use the amount of loss per trade; others use drawdown or such things as variability of returns or price volatility. I first define risk as the amount of money I will lose at the price I will get out of the trade. If that price is touched—whether because of news spikes or because I was wrong in my analysis or because of some unforeseen event—then I take the loss. That amount is my risk for any given trade. This is the first number I look at when deciding whether to place a trade and I look at it regardless of how confident I am that the trade is a good one. No matter how skillful my analysis (and I believe I am skillful), I do not have a crystal ball and cannot predict with 100% certainty what the market will do. Nobody can. So my first question to myself is can I stand to lose this amount of money.
Only after I know what I can lose do I look at the potential return. The potential return has to be at least two times and better three times the risk taken. If my risk is $1,000, I want to see a potential return of $2,000 to $3,000 and preferably more. If that return is not possible, I don't want to be in the trade. Notice that I use dollars since dollars will affect my mood most. This is true for most traders. If one uses tiny positions, a trade can move against you by hundreds of pips with no significant dollar impact.
How much you are willing to risk should be in your business plan. Sometimes traders know the amount but don't realize when they've taken on additional risk of the same type. For example, assume a long position in GBPUSD with a potential $1,000 risk of loss. If one goes long in another correlated pair—one that tends to move in the same direction as the Cable—then that is two trades. If they each carry a potential for a $1,000 loss, the risk of loss is $2,000.
What this implies is that in assessing how much risk one is comfortable with for each trade, one must also look at the overall account equity. It's common to hear that one shouldn't risk more than 1% of the account. However, even a couple of correlated trades can push it well above that. Part of my daily routine—another part of my business plan—is to review correlation. Another need is to determine the correct position size.
For example, let's say I decide to go long the AUDUSD today, 12/29 at 1.0174. That would be very dumb given this illiquid market but this is only an example. I buy 100,000 units. Where do I place a stop? The low yesterday was 1.0073 so let's use 1.0069 as a stop. I do not necessarily recommend this approach to stop setting but stops are a different subject. My potential loss is $1,048 (105 pips) and I use margin of $2,034.84 for a trade value of $101,742. In order to have even a 1:2 risk/reward ratio, the pair would need to move up 210 pips to 1.0384. But there's another problem. How big is my overall account? If it's small, i.e. $10,000, I'm tying up 20% of it in one trade. Is that a good idea? Probably not, although a definitive answer would require knowing what type of trading methodology one was using and considering the probability of success of any given trade. When one begins to factor in such issues as that, one can see how risky this entire proposition is, even though it looks as though I'm near my risk tolerance of $1,000. Reflecting on all these factors provides real insight into why so many people lose all their money when they begin trading. Using a hypothetical account size of $10,000, one would want to reduce the above position from 100,000 units to possibly 50,000. I still think this is too high for small accounts but it's a better risk position (including potential loss) than the original. But even with this reduced amount, it would only take a string of 20 losses (not impossible) to wipe out the account. I repeat—this is an example only. Nobody should be trading these illiquid markets even if the AUDUSD is at a potential breakout point. It could also be at resistance.
So risk is multifaceted. It begins with the potential loss on any given trade. It extends to overall size of the account, leverage, and size of the trade. It also includes the probability of your trading methodology. All aspects should be in your business plan. The time to decide upon acceptable risk is in advance of deciding upon any particular trade.
© Dianne Fecteau, 2010. No part of this material may be reproduced in any form, or referred to in any other publication, without the express written permission of the author.
My purpose in writing this blog is to show you how one trader, me, makes trading decisions and survives while trading Forex. One of the biggest problems I had when I first started trading was trying to apply the “rules” to actual trades. Another was the psychology—limiting losses and letting profits run. If you study my blog, you’ll see how I deal with both those issues. So my writings are not trade recommendations but rather educational in purpose. You have to decide on your own approach to trading. Remember that trading is risky.