Updated: May 21
Risk management is one of the most important tools you have as a trader when it comes to maximizing profits and minimizing losses in Forex trading, but also in trading other markets, or even investing. If you have an edge and combine that with good risk management you can massively increase your performance. Risk management is often overlooked. The only thing retail traders know about risk management is to risk 2% per trade. This is such a shallow view and limits your profits massively. In this article you are going to read some interesting things about risk management. However, this will not be all there is to it. If you want to know more about risk management you might want to check out our coaching or modules.
If you apply these things correctly, you can massively increase your performance and reduce your losses.
Risk is personal
To start off with this important topic it’s very important to notice that risk is personal. Everyone has a different level of risk tolerance. Some people can get risk a lot and don’t feel any stress because of it. Others might experience stress when risking a lot and have do reduce their risk. Because of this, you won’t find any clear cut rules about risk management in this article, but rather an action plan with a lot of tools. In Forex trading nothing is certain, not even how you approach things.
Define your goals
Before you go into deciding how much you are going to risk and how you are going to calculate the risk it’s important to figure out your goals. Different goals need different ways of risk management. Some goals can be:
· Growing a small account
· Capital preservation
· Building a trackrecord
· Trading for investors
· Trading for a firm
Each of these goals needs different ways of risk management. If you try to grow a small account your focus is on maximizing gains, not on slow and steady gains. You only want to take setups with the biggest edge and risk the most amount possible on those. This way you can grow the fastest and most aggressive.
However, if you apply this technique while preserving capital this is not going to work. When you want to preserve capital it’s all about low risk and low returns. The goal is not to grow the money but rather to combat inflation. Usually this is not done in Forex trading but by investing in bonds. However, it is still possible.
Hedging is one of the tools banks use to hedge against their investments in foreign products. The Forex market is the biggest market. Most of the money is being brought in by big banks and is done for the purpose of hedging. As a Forex trader your primary goal usually is growing capital, not hedging. However, it can be done. Let’s say you have an equity portfolio filled with US Stocks. If the Dollar loses value your stocks will. To hedge against the dollar you can be long on the EURUSD for example. Using gold is also a common way to hedge against the dollar.
If you are trying to build a trackrecord as a Forex trader you have to be very detailed and professional. Trackrecords are used to show your performance with the goal to get more capital from private investors or companies. When you are building a trackrecord the goal is maximum return with the lowest drawdowns & risk.
When you trade for private investors you have to take the personal risk appetite of the investor into consideration. You have to talk about the drawdowns you are going to make when you risk a certain way.
When you are going to trade for a firm you often have to follow the firm’s risk rules. You need to know these rules and adjust your risk management to that.
As you can see there are a lot of different goals in Forex trading. So, when start deciding how you are going to apply certain risk management techniques, figure out your goal first.
The risk of ruin
The risk of ruin is the risk of blowing your account. In Forex trading you often hear stories about people blowing their account. The only reason this happens is because of poor risk management. The risk of ruin shows how much you can risk per trade, maximum, without blowing your account. You always want to be well below the risk of ruin. Black swans can happen, but you also need to leave room for mistakes. Calculate your risk of ruin. There are a lot of sites that have a simple calculator that can help you calculate your risk of ruin. Once you know your risk of ruin, stay below that. Most people that do Forex trading don’t even know about the risk of ruin. If you know this, you are one step ahead of them.
Taking a look at your performance
Once you know what your goal is when it comes to trading and you know your risk tolerance level it’s time look at your past performance. In Forex trading, just like trading any other market, nothing is certain. The only thing you have is past data and fundamental information.
If you have an edge, which you should, otherwise you shouldn’t even be trading the Forex market, it’s time to analyze it.
Look at your past performance. This can only be done if you have a trading journal. If you don’t have one, get one now. In another blog on this website we will tell you more about how to make a trading journal to get better at Forex trading. When you look at your past performance there are two things you want to ask yourself:
· What works the best?
· What doesn’t work, or works less?
By answering these two questions you can figure out what works best and what doesn’t. Then, you can allocate your risk accordingly. Let’s give you an example:
Let’s say you have a strategy with edge and you notice that once a false breakout happens the day before you enter a trade, the odds of a winning trade increase with X%.
So for example, normally your winrate is 60%, but in this scenario it will be 70%. Conventional educators will just tell you to risk 2% per trade. We at CDFX Trading belief this is the worst advice anyone can give. Why risk the same on something that works better? If you risk more during the times your strategy works better and less during the times your strategy performs less you will massively increase your payout, without changing anything about the way you trade. This is essentially free money! This can also be done with things that work less.
Let’s say, by looking at your journal, you figure out that on certain days your winrate is only 50%, but you still have an edge. Why risk the same on this day and also risk the same when your winrate is 70%?
You can for example apply this:
· Risk 1% on the 50% winrate setups
· Risk 1.5% on the 60% winrate setups
· Risk 2% on the 70% winrate setups
This will increase your payout without changing anything about your strategy. This might be the holy grail in Forex trading.
When applying this you have to keep in mind that winrate is not everything. There are also other factors that come into play such as average R & risk of ruin. This is just to illustrate that you can increase your performance in Forex trading by reviewing your past trades, finding out what works and what doesn’t and adjusting risk accordingly.
Putting it all together
When it comes to risk management there are a lot of components that go into it. This article described a few, but there is more to it. If you want to know more about increasing your performance in Forex trading, check out our 5 month 1-on-1 coaching program.
So, can you get started with getting better at risk management and increase your profits?
1. Determine your risk tollerance
2. Determine your goal
3. Determine your risk of ruin
4. Find out what works best and what doesn’t
5. Allocate risk accordingly
Start by figuring out your goal in Forex trading and figure out how you need to adjust your risk management to achieve that goal. While doing that, analyze yourself and figure out your own personal risk tolerance level. Next, calculate your risk of ruin based on your past performance. Then, look at your journal and backtest results. Find out what works and what doesn’t. The only way this can be done is by having a journal. So get one, otherwise you can’t improve. When you have figured out what works and what doesn’t allocate risk accordingly. Allocate more to what works, but stay in your risk of ruin, and less on what doesn’t work that good. You maybe even want to cut things out in order to increase performance. There are a lot of ways you can do this, but it all starts by becoming aware and taking action.
If you have any questions about risk management, feel free to contact us!