In this article I explain why risk management is important, how it can be measured, and how better risk management can be implemented quite easily using a few trading and accounting tools and tricks. If you follow my words, you will likely find this increases your overall profitability by more than searching for a “holy grail” trading strategy ever will.
1. Use Astute Personal Financial Management
2. Use Notional Capital
3. Know the Historical Probabilities of Your Trading Strategy
4. Size Your Positions Accurately
5. Use Robust Trade Management
Please read on to hear me explain how to implement them.
Defining Risk by Return with the Sharpe Ratio
A trader’s job is to deliver superior risk-adjusted returns, not nominal returns. This is because if you are making great profits but doing it in a way that is statistically likely to blow up your account sooner or later, you are really doing worse than if you were losing a little money during a difficult market period.
A trader’s success is not measured best by overall return, but rather by how much is risked in making that return. The Sharpe Ratio was designed as a metric to identify good risk managers. It is calculated by dividing the return by the volatility of the return (how much the return fluctuates) – a higher Sharpe Ratio is better as it shows returns were achieved with lower drawdown. So, let us compare the hypothetical performances of two investment managers, using the Sharpe Ratio:
50% annual return with a standard deviation of returns of 70% à the Sharpe Ratio will be 50/70 = 0.71 which means that the manager is arguably not producing a great return considering the amount of risk he or she is taking to get it. A Sharpe Ratio should ideally be higher than 1.
Here is what a typical equity curve with a low Sharpe Ratio could look like:
Equity Curve with Low Sharpe Ratio
Compare the performance of Manager A, which was positive but volatile, to Manager B who achieved an annual return 12% per year with a standard deviation of returns of 7.9% à the Sharpe Ratio will be 12/7.9 = 1.52.
Equity Curve with High Sharpe Ratio
Which Manager would you prefer to invest in?
The correct answer should depend on your individual risk tolerance. But know this: professional money managers wishing to attract large amounts of investment capital all work towards minimizing volatility of returns, so that investors will enjoy as smooth a ride as possible.
By minimizing volatility of returns, the money manager is proving to potential investors that:
- only taking on certain acceptable well-known risks are being taken,
- he/she knows when to reduce trade size and frequency,
- he/she knows when to augment trade size and frequency,
- he/she does not allow losses to run and risk becoming bigger losses.
Does this sound like the kind of trader you would like to become? If so, read on while I explain how to understand what risk management in Forex is, and how to develop a structured approach to measuring and managing risk in a consistent way.
What is Risk in Forex?
To properly understand what it means to manage risk, we need to understand what “risk” is in the first place. Here is an illustrative example:
- Trader A in the USA buys stock XYZ listed on the NYSE because he/she believes it is undervalued and is starting to show positive momentum.
- Trader B in the USA does the same as Trader A, but also buys a put option (where you make money if the price of the underlying asset goes down) on the S&P 500 stock market index.
- Trader C in the Eurozone does the same as Trader B.
Which trader was most efficient at exploiting the undervalued situation of stock XYZ?
I hope you will agree that the correct answer is Trader B.
Trader A is not only exposed to the risk that XYZ stock will decline in price. Since XYZ will be influenced by the broader stock market, Trader A is also exposed to adverse movement in the broader stock market, represented by the S&P 500 index. Trader A is also exposed to the risk of an increase in value by the US dollar, which would logically make the price of XYZ go down.
Trader B also sought to exploit the undervalued situation in XYZ and, only wanting to take on this specific risk and no other, hedged away broader stock market risk with his put option on the S&P 500 index. A similar (but more expensive) hedge would be to sell an appropriate quantity of futures or ETFs on the S&P 500 index.
Trader C is in a worse situation still. He bought XYZ and bought a put on the S&P 500 index. However, he did not hedge his currency risk – euros are his base currency. By buying a US stock denominated in USD, he is implicitly short EUR/USD. So, if his stock trade works, but at the same time the US dollar declines, he will not have the profit he expects because the currency movement will have eaten away at his profit.
Here are a few kinds of risk that your portfolio or trade may be subject to:
1. Market Risk: the risk that the market will perform differently to how you expect. This is the most common risk in trading.
2. Counterparty Risk: the risk that your broker will default or fail to return your funds (this is a real risk, and that is why it is best to use notional funding).
3. Liquidity Risk: the risk that you will not be able to open or close trades when you desire.
4. Model Risk: the risk that your trading model or your analysis model fails to accurately represent reality and will lead you into a series of trades or decisions that lead to losses.
5. Technological Risk: the risk that your computer, internet access, or anything IT-related will fail. For example, what if your broker’s platform fails to respond and you continue clicking, only to find out it was a lag and you opened 5 positions in the same direction?
6. Risk of Ruin: the risk of blowing up your account.
Avoid the Need to Be Right
Another component of Forex risk management has to do with the emotional need to be right. Aspiring traders typically try to devise ways to avoid losses and/or recover drawdowns immediately. Usually, this is expressed by an attempt to implement a martingale position sizing algorithm (i.e., doubling the risk on the next trade after each loss). The belief is that “the more losses in a row I get, the more likely it is that the next trade will be a winner”. Notwithstanding the fact that this is a fundamentally flawed understanding of probability in Forex trading, the following questions also need to be asked of this approach:
1. Even if you had infinite capital, at best you would break even by this approach. Do you have infinite capital?
2. If you double down and do not win, how many consecutive losses can you take before being wiped out? What is your risk of ruin?
3. Doubling down means throwing good money after bad money, the opposite of cutting losses.
These reasons are why a traders’ focus must be first on limiting risk and managing risk well, not taking on more risk to recover from losses. It is too easy to think about the potential gains that are possible trading the markets, without paying equal attention to the exponentially challenging battle that awaits if you let your losses get out of control.
Another issue is that the more you lose, the greater the percentage gain required to make up your loss and get back to even. Once you lose more than 20% of your equity, the gain required begins to really increase exponentially, as shown by the diagram below.
Gain Required to Recover from Loss
If you lose 20% of your account, it takes a 25% gain to break even. If you lose 50% of your account, it takes a 100% gain to break even. If you lose 70% of your account, it takes a 233% gain to break even. If you lose 90% of your account, it takes a 900% gain to break even.
There is only one solution: ensuring that your average profit is larger than your average loss. If your average win is twice as big as your average loss, you only need to be right 33% of the time. This is the math you need to drill into your head.
Relationship Between Reward to Risk and Win Rate
This implies the use of a stop loss which keeps losses small compared to potential gains. This also implies cutting losses. But also, without actually experiencing the large gains, traders will never break the vicious cycle of needing to be right. So, you also need to let your winners run.
How to Calculate Risk Management in Forex
Now we get into the nitty-gritty of Forex risk management practices. There are several steps to building a proper risk profile and establishing clear risk limits. At the end of the day, this exercise connects:
• risk limits
• win rate
alongside sound objectives and common sense.
Step 1: Astute Personal Financial Management
Starting from the top, the capital you allocate to your trading account should be money you can afford to lose. Your savings account is NOT your risk capital. Your risk capital for trading should be weighted within the overall picture. Identify a sum you can afford to lose, and always remember that if you lose it, you’re out of the game. Typically, it should be no more than 5-10% of your savings.
Step 2: Use Notional Capital
Imagine you have $10,000 you are willing to risk, and you have proven yourself on a Forex demo account for at least three months. What should be the next step? I believe in deploying risk capital based on merit. Initially, deposit 10% of your risk capital with the broker. That would be $1,000 in our example. You will probably start trading with micro lots, but there are certain benefits:
• you will be “almost” demo trading, because the amounts will initially be quite small, so psychological pressure will be minimal;
• you will still have 90% of your risk capital in the bank in case your broker defaults.
If, after the first month, your results are positive, you can bring another 10% into play during the second month, hence increasing your trade size. Refrain from adding to the account if you are at a loss after the first month. The objective is to deploy your total risk allocation over the course of your first year of trading based on:
• the amount of risk capital you possess (the larger it is, the more you can dilute it);
• your trading results (only add if your trading is convincing).
The bottom line is that your account balance will grow alongside your experience level, and you give yourself more time to survive, trade and learn.
Step 3: Know Your Probabilities
Many aspiring traders are foreign to the concept of risk limits. They take their risk capital, throw it into an account, divide it by one hundred to come up with a fixed risk per trade. Risking a fixed 1% of your account is certainly better than having no plan at all, or betting 5-10% per trade (which is far too high and will stack the odds of survival firmly against you). But this reasoning does not insulate you from drawdowns or overtrading.
Traders generally underestimate the probability of an extended losing streak. In the chart below I illustrate the probability of at least 1 occurrence of losing X times in a row over the next 10 trades. In case you are interested, the excel formula utilized to generate the calculations is:
= 1 – binomdist (0, A – B + 1, C^B, false)
A = n° of trades to consider (10 in our example)
B = n° of consecutive losses to evaluate
C = probability of loss in a single trial = 1 – %win
Strategy Win % and Probability of Losing Streak Size
If you are a day trader and trade 10 times per day with a 50% hit rate, you can still expect to have 3 or 4 losses in a row. So, if you risk 1% per trade, it is logical to expect a 4% drawdown once every 3-4 days and a 3% drawdown most days. If you do not have a very robust mindset and model, it does not take many of those occurrences to deplete your risk capital.
I therefore suggest reducing the number of trades through a quality filter of some sort and decide on a maximum permissible risk per day. If your trading model generates 3 to 5 trades a day, then you split your risk allocation into 3 or 5 and that means risking anywhere from 0.20% to 0.33% per trade. These are realistic numbers to work with.
Swing traders may want to think in terms of maximum risk per week, and position traders might want to think in terms of maximum risk per month and calculate the probability of X consecutive losses along that timeframe.
Step 4: Size Your Positions Accurately
Risk Limits and Position Sizing are interlinked via trade frequency. Most retail traders have the bad habit of trading too often so I always suggest filtering “quality trades”. However, it is useful to have a backup plan to continue trading even through a string of losses and the most logical way to achieve this is by cutting the position size by 50% if you lose half of your initial risk for the month.
Imagine having a 3% risk limit for the month, starting at 0.5% and after 3 trades you are down by 1.5%. At this point, reduce the trade size to 0.25%. The 7 remaining trades will still allow us additional opportunities, which will hopefully make up for the initial loss.
Beyond that drawdown cut-off, the way to accurately size your positions is to link them with your equity curve and build a “position sizing ladder” which is something Tom Basso and Van Tharp have spoken about at length. For example:
Position Sizing Ladder (Source: Author’s Calculations)
You can build a ladder that is as aggressive or as conservative as you wish. The point being: you risk more when you are winning (and have winnings to risk) but you cut down your risk exposure when you are losing (hence conserving initial capital).
Step 5: Have a Robust Trade Management Vehicle
I covered this in-depth in an earlier article about trade management.
As a trader, your primary concern should be managing risk with a good Forex risk management strategy. The main risk I discussed in this article is related to market risk and we identified 5 tips to manage risk in Forex trading:
- Trade with money you can afford to lose.
- Use notional capital to fund your account.
- Know your probabilities and your own trading model’s statistics on consecutive loss counts.
- Use a position sizing ladder and a max drawdown cut-off.
- Have a solid trade management strategy.
Together with a relaxed mindset (not “wanting” or “having” to trade) and absolute clarity on what your trading model does (know what your “edge” is), these steps will keep you out of trouble and, like me, you should never risk blowing up an account and so remain in the trading game forevermore.
How do you manage risk in Forex?
There are various ways to manage risk in forex trading. I have highlighted 5 ways to do so: risking money you can afford to lose, funding your account with notional capital, knowing the probability of consecutive losses, having a position sizing ladder and solid trade management practices.
How can you reduce risk in Forex trading?
Reducing risk in forex trading is simple: you can trade with smaller position sizes, or if you are in a trade, you can close part of the trade which will free up margin and allow you more “breathing room”.
Why is risk management important in Forex?
Forex has low entry barriers, and you can literally fund an account with $10 or even less at some brokers. This leads many people to treat forex like a lottery ticket, risking their entire account on each trade. Perhaps sometimes they get lucky. But there is no future in such practices.
To become a professional trader and attract serious capital, you must survive through various market cycles, and you need to develop skills that will limit your downside. That is what risk management does.
What is the safest way to trade Forex?
The safest way to trade is to know how much you are willing to lose on any given trade, and not exceed it. Set a stop loss that will cut your loss at that given amount and stick to it.