Forex Risk & Money Management
1. Money management is important, as it lets you live to tell the tale.
2. The performance of a system, in terms of profits, drawdown, or any other parameter you want to measure, depends on both the system itself and the money management rules it uses. A system should suggest a range of acceptible money management method or rules which gives best results, that is, good profits and an acceptable drawdown.
So how is money management done?
We’ve talked about why they are crucial, but what is an example of how you use them to actually calculate your trade sizes?
Let’s have a look at a method of money management that’s often used, called the percentage risk method.
Note that this is not the only method of risk management, and some systems do use a different risk method. But it is frequently used, and is good one for you to understand, so that you can then compare risk methods to each other.
The percentage risk method as a money management method, aims to “risk” the same percentage of your cash float (not the same trade size) per trade. Note that you won’t have the same trade size for each trade necessarily.
This method relies on knowing:
1. The stop loss size of the trade, and
2. The percentage risk (of your unleveraged cash float), that you want to risk per trade.
So this percentage risk method says that there’ll be a certain percentage of your cash float that is at risk per trade. And to know how much is actually “at risk” in a specific trade, you need to know the above two parameters: the stop loss size for that trade, and the percentage risk that you’ve chosen.
So now that we know how much is at risk per trade, how do we calculate our actual position size for a particular trade?
For currency pairs where the USD is the terms currency
Let's firstly take the situation where we're trading a currency pair where the USD is the terms currency, such as EURUSD, GBPUSD, AUDUSD. To work out our trade size (face value), you would need to know the stop loss size of the trade. So:
Face value (of base currency) =
For currency pairs where the USD is not the terms currency
What happens if your float is in say $USD, but the USD is not the terms currency? This occurs when you’re trading the USDCAD, USDCHF, USDJPY for example.
In this case, you’d need to do an extra step, which is to adjust the stop loss size in the terms currency, to its value in $USD. That is:
Stop loss size in $USD pips =
For example, if you’re trading USDCHF , and the stop loss size was 55 pips, and the currency rate for this pair was 1.2878, then:
Position Sizing Part 2: Maximum Number Of Open Positions
A final point to consider would be the maximum number of open positions, that is the maximum number of trades that you want to be in at one time.
This is the other factor to decide when managing risk.
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