Forex Risk & Money Management

Risk and money management, or the art of position sizing, is an important part of your forex trading as you’ll soon find out..

Why?

Because it determines whether you’ll be able to keep trading as long as you like, to continue making your profits :)

In any system, you’ll encounter both winning and losing trades. So you’ll want to be able to easily handle any losing trades, and continue to trade the winning trades at the same time, so that you have a profitable system.

That’s what forex money management is all about.

As an extreme example, if you put say a large chunk of your float into each trade without a position sizing model, and you make a profit, great, your profit will be much bigger than if you did have position sizing rules. So far so good. But if your next trade is a loss, you may lose your float, and that’s the end of the trading!

Let’s take a more realistic example.

Let’s say that your forex trading system has an 80% win-loss ratio, and that the size of your winning trades are on average 3 times that of your losing trades. This is your trading edge. This is why you can profit from your trading, whereas someone else who has no system, or is using an ineffective system, is unlikely to profit except out of pure luck.

But even with this trading edge, you may hit a string of losses.

So even with a good system, you still need to have an appropriate money management model to survive and prosper...

Let’s look into it a bit further.

Let’s say that you’re trading a cash float of $5000, leveraged up to $500 000, that is with 100:1 leverage. And let’s say that the maximum drawdown of your system historically is $2000, when following a particular money management method. So in this case, the drawdown is 40% of the cash float. Maximum historical drawdown refers to the biggest decrease in the cash float that has occurred in the past when backtesting or trading your system.

Now if you’re trading a good profitable system, then with the risk management rules that the system is designed to use, you can go on to make the profit that year that the system will generate. Say the system made 500% on your cash float that year. This means that by trading with that system, and its money management rules, you were then able to overcome this 40% loss, to end up 500% in profit.

That is, you rode through the drawdown period, continued trading and made this tidy profit.

And another reason to have appropriate money management is that in the beginning, you may make mistakes in your trading. So your losses in the beginning days may be higher than necessary.

That's why money management is important for any trading, including forex trading.

So let’s summarise these two crucial points so far:

1. Money management is important, as it lets you live to tell the tale, and profit well!

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.

Money Management Part 1: Percentage Risk Method

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.

As an example, let’s say that you’ve chosen a percentage risk of 2% of your cash float. If your cash float is $5000, this means that you’d want to risk 2% of $5000 per trade, which is $100. So with every trade, the maximum you’d lose (assuming no gapping or slippage) would be $100.

With this chosen percentage, it would take you 50 losses in a row before you’d lose all of your float (50 x 2% = 100%). Assuming that your system is a good one, then 50 losses in a row would be very unlikely.

If your system for example has an 80% win loss ratio, and that the maximum number of losses in a row historically was 7, then getting 50 losses in a row is very unlikely. The chances of this happening in fact is 0.2 to the power of 50, a very small number.

On the other hand, if the risk chosen was 4%, then it would take 25 rather than 50 losing trades in a row to lose the entire float. So as you can see, the number of losing trades required to lose the float decreases as you increase the percentage risk.

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:

Assuming:

Cash float is $ 5000 USD
% risk is 2%
Risk per trade is $100 USD (500 x 0.02), and
We’re trading a currency pair where the USD is the terms currency

Face value (of base currency) =

So for example, if we’re trading the EURUSD, and the stop loss size for that trade was 30 pips, then our stop loss size would be equivalent to 30 pips in USD, because if you make a profit or loss, it is in the terms currency. Therefore:

Face value (of base currency) =

Face value (of base currency) = 33 333

That is, 33 333 of the base currency, which in this example, is the EUR.

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:

Stop loss size in $USD pips=

Stop loss size in $USD pips = 43 USD pips.

You’d then use this number in the formula above to calculate your trade size or face value:

Face value (of base currency) = risk per trade in $USD / stop loss size in $USD

Face value (of base currency) = 100 / 0.0043

Face value (of base currency) = 23 255 USD.

Now, when looking at money management, also take into consideration your maximum number of open positions.

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.

If for example, you chose a 2% risk, you may also say chose to be in a maximum of 4 positions at any one time. If all 4 of those positions close out at a loss on the same day, then you would have had an 8% decrease in your cash float that day.

This is a decision that you will have to make for yourself, though many systems will have a guide about this for you. In the beginning, your maximum number of open trades may depend on how well you know the system. You may find yourself starting with fewer trades on at the same time in the beginning, and considering a larger number as you get used to trading the system.

Forex Money Management: Putting It All Together

So putting it all together, all the way from how much float you have to how much profit is made from a trade...

As an example, let’s say that you had a cash float of $10 000 and so your leveraged float is $1 000 000, and you used the fixed % risk model.

For a trade where the stop loss size was 30 (terms currency) pips, and assuming a fixed % risk of say 3% (which is $300) of your cash float , your trade size in this trade would be 300/0.0030 = $100 000 worth of base currency.

If your profit was then 75 pips, then this would be $750 worth of the terms currency (as the face value traded was $100 000).

So there you have it.

An extra tip here for calculating the stop loss size:

Remember that when you’re looking at a chart, that you’re looking at the bid prices (most charts display bid, not offer, prices). Then as you set your stop loss, on many platforms, you have the choice of “stop if bid” or “stop if offered”. So say you were in a short trade, having entered at 1.2880, and your stop loss is at 1.2840. And according to your system rules, all stops are set as “stop is bid”.

When you’re stopped out, you’d be buying when the bid price reaches 1.2740 because you’ve used “stop if bid”. But because you buy at the offer, your actual buy price would be at say 1.2843, due to the spread. Your stop loss is therefore actually 37 pips, not 40 pips. A small point, but one which often causes confusion.

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