The nitty-gritty of risk management
I’m always disappointed by the level of the conversation about risk management.
Risking 1%-2% per trade is not the magic bullet that Forex educators seem to think it is.
Sure, it’s better than risking 5% of your account per trade, but the concept of risking 1% or 2% per trade is much better suited to system traders than rules-based discretionary traders like us.
In-fact I suspect the whole 1-2% came from futures trading when are large number of traders try to emulate the famous turtles* who were 100% systematic trend followers.
So why should traders, when they can risk whatever they want in order to achieve their goals, limit themselves to such a formulaic approach to risk management?
It’s time to get creative people! And think outside the 1-2% box.
Your position size should reflect your objectives.
It’s funny how an off the cuff comment can change the way you trade so much.
I was in a workshop with Van Tharp (an original Market Wizard and trading psychologist) and we were discussing objectives. Van off-handedly remarked that if he was day trading he would have a position-sizing model with the objective of risking 2% a month, while targeting 25%.
For me this sparked a new paradigm, and I went about developing a position sizing model that let me risk 2% and make 25%. As you can imagine risking 1 or 2% of your account a month is not at all sophisticated enough to reach this objective.
The point of this little story is that if you want to get serious about risk management your objectives come first, followed by your position sizing model. Be creative about setting the right objectives for yourself first and then your risk management rules can reflect these goals.
Minimise your risk to your core capital
One of the keys to successful trading is limiting your risk to your core capital (again this is not something that the 1-2% model does well). By limiting your risk to core capital you:
- Stay in the game
- Protect your psychology
- Stop revenge trading
Unless you are a gun trader and really know what you are doing I would suggest limiting your risk to at most 3% a month. As discussed previously losing 3% in a year is almost enough to get someone fired in the money management space.
How to risk no more than 3% a month and still make decent profits?
Here is the nitty gritty.
You start by risking a small amount, say 0.5% of your account. If your equity falls you then start to risk less: 0.4%, 0.3%, 0.2%, 0.1% and then stop for the month if your account hits the loss limit.
Once you have winning trades you scale your position size back up again.
Once your account is in the positive for the month you can start to trade bigger: 0.5%, 1%, or even 2% of more. Once you get close to your monthly target, depending on how long you have to go in the month you can then reduce your position size so you don’t go giving back your gains.
Don’t forget you can add to winning positions too if you get a re-entry signal. This means you can scale into winning positions as the market goes up using your profits on the earlier position to take more risk. There are plenty of ways to build positions – which I will share with you in a future post.
Length of the trade
Another way to alter your position sizing is to risk different amounts depending on the length of the trade. For short term trades you would risk less than for long-term trades.
- Short-term 0.1-0.5%
- Medium-term 0.5-1.0%
- Long-term 1.0-3.0%
The best traders don’t trade the same amount each time they trade. If they are confident in a position they will be prepared to risk more, if they are not so confident they risk less.
Of course this needs to be within your risk management limits and based on the market that is in-front of you. It’s not an excuse to risk big, to win back your losses.
You are not a robot, so why not use all the advantages you have and alter your positon size based on your assessment of the quality of the trade.
Risk Management is a process
It will take some time to build a risk management model that fits you.
So take some time away from your charts and reflect on the content of this post.
- What objectives are right for your trading?
- How much of your core capital are you willing to risk?
- Do you need different position sizes for different length trades?
- How will you adjust your position-size based on your confidence level?
Stay disciplined in your trading.
*The Turtles are a group of futures traders hired by William Eckhart and Richard Dennis to settle the debate over whether traders need to be born with it or can be grown.
About the Author
Sam Eder is a currency trader and author of the Definitive Guide to Developing a Winning Forex Trading System and the Advanced Forex Course for Smart Traders. He is a key team member at premium FX services provider www.fxww.com and part owner of Forex Signal Provider FX Renew (You can get a free trial). If you like Sam’s writing you can subscribe to his newsletter for free.