By Jeremy Wagner, Lead Trading Instructor, FXCM
The fact is that most traders, regardless of how intelligent and knowledgeable they may be about the markets, lose money. Are the markets really so enigmatic that few can profit or are there a series of common mistakes that befall many traders? The answer is the latter.
The good news is that the problem, while it can be emotionally and psychologically challenging, can be solved by using solid risk management techniques.
Today, we will discuss 2 key aspects of risk management.
1. Risk a little to make a lot ? use at least a 1:2 risk to reward ratio
2. Risk a small portion of your account ? risk less than 5% of your account on all open trades
Use at least a 1:2 Risk to Reward Ratio
Last fall, DailyFX published their Traits of Successful Traders. We went through extensive research on the behaviors why most traders lose. Most traders lose money simply because they do not understand or adhere to good money management practices.
Part of money management is essentially determining your risk before placing a trade. Without a sense of money management, many traders hold on to losing positions far too long, but take profits on winning positions prematurely. The result is a seemingly paradoxical scenario that in reality is all too common: the trader ends up having more winning trades than losing trades, but still loses money (see chart above).
To resolve this paradox, establish your risk and reward parameters ahead of time. Insist on taking trades that offer at least a 1:2 risk to reward ratio. This means that for every pip of risk you are taking in the trade, seek out at least 2 pips of potential reward. By doing so, you are relieving the pressure from yourself to have to be right in the trade.
As James Stanley eloquently points out in his trading plan, you can be right only 50% of the time when using a 1:2 risk to reward ratio to give yourself a shot at consistent returns.
Risk no more than 5%
However, there is another element to consistent risk management. How much of your account are you risking?
Too often, I hear from clients via twitter or during our live webinars that they are risking a small amount, just 20 pips on the trade. However, the true risk on the trade is how much of your account balance are you exposing?
Is it possible that Trader A can have a stop loss set at 10 pips and risk more than Trader B with a 50 pip stop loss? Yes!
As you can see from the above example, the trade size (and resulting cost per pip) multiplied by your stop distance determines your risk on the trade.
In our courses, we suggest risking no more than 5% of your account balance on all open trades. That way, if you are wrong (and we established from the first key point that it is ok to be wrong 50% of the time), then you still have over 95% of your account balance available to trade tomorrow.
The formula to calculate risk on the trade is:
Cost per pip X pip's risked = Account Balance Risked
For example, if I'm trading the AUDJPY with a current pip cost of $1.25 per 10k position, then a trade with 50 pips of risk is $62.50 risked in my account.
[ $1.25 X 50 pips = $62.50 ]
The views expressed are not FNArena's (see our disclaimer).
For real time news and analysis, please visit http://www.dailyfx.com/real_time_news
DailyFX provides forex news on the economic reports and political events that influence the currency market. Learn currency trading with a free practice account and charts from FXCM.
The original story can be accessed at: http://www.dailyfx.com/forex/education/trading_tips/daily_trading_lesson/2012/07/06/Why_Do_Most_Traders_Lose_Money.html
Forex Capital Markets is headquartered at Financial Square 32 Old Slip, 10th Floor, New York, NY 10005 USA.
Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before you decide to trade the foreign exchange products offered by Forex Capital Markets, LLC, Forex Capital Markets Limited, inclusive of all EU branches, FXCM Asia Limited, or FXCM Australia Limited, any affiliates of aforementioned firms, or other firms under the FXCM group of companies [collectively "FXCM Group"] you should carefully consider your objectives, financial situation, needs and level of experience. If you decide to trade foreign exchange products offered by FXCM Australia Limited you must read and understand the Financial Services Guide and the Product Disclosure Statement. FXCM Group may provide general market information and commentary which is not intended to be investment advice and the content of this email must not be construed as personal advice. By trading, you could sustain a total loss of your deposited funds and therefore, you should not speculate with capital that you cannot afford to lose. You should be aware of all the risks associated with trading in foreign exchange products. Foreign exchange products are only suitable for those customers who fully understand the market risk. FXCM recommends you seek advice from a separate financial advisor.
FXCM Group assumes no liability for errors, inaccuracies or omissions in these materials and does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. FXCM Group shall not be liable for any special, indirect, incidental, or consequential damages, including without limitation losses, lost revenues, or lost profits that may result from these materials. This email is not a solicitation to buy or sell currency. All information contained in this e-mail is strictly confidential and is only intended for use by the recipient. All e-mail sent to or from this address will be received by the FXCM corporate e-mail system and is subject to archival and review by someone other than the recipient."
If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.
Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" - Warning this story contains unashamedly positive feedback on the service provided.
Our archive tells no lies. FNArena warned its readers well before the price of crude oil peaked in 2008 the speculator bubble would deflate with devastating consequences for those holding oil company shares. In August we warned the most severe correction in modern history was forthcoming for natural resources. In 2007 we warned the problem with US subprime mortgages would prove much bigger than experts and media were anticipating (among other things).
FNArena is showing the true value of truly independent financial analysis and reporting. Our daily news reports can be trialed at no cost and with no obligations at www.fnarena.com. Simply sign up and see it for yourself.
Subscribers and trialists should read our terms and conditions, available on the website.
All material published by FNArena is the copyright of the publisher, unless otherwise stated. Reproduction in whole or in part is not permitted without written permission of the publisher.
Keep reading - next article