Perhaps one of the biggest anxieties that people have about forex trading, is that they fear it is risky. Yet effective and easily implemented risk management strategies can greatly reduce potential losses.
There are risks with other income streams as well. According to Bloomberg, 8 out of 10 entrepreneurs who start businesses fail within the first 18 months. That is a whopping 80% crash and burn.
Employees are vulnerable to being laid off when their employers face hard times: the workers are usually the first to go, long before the management and owners face redundancy.
Landlords and property owners sometimes find that their tenants do not always pay the rent. In addition to the loss of income, tenants may cause extensive damage to their property, that is difficult and expensive to repair. Evicting tenants can be a time consuming, long drawn out, and costly legal process.
A trader’s security is considerably enhanced when operating strictly within a well-tested and well-proven trading plan.
An effective risk management strategy is to trade with a minimum of a 3:1 positive risk to reward ratio. That is, a profit three times greater than the potential loss.
Imagine trading three times, each with a risk reward ratio of 3:1 and a £100 risk. The following table shows the possible scenarios that can occur.
Despite losing two trades in every three, and losing more trades than wins, a trader can still generate a profit. Only when all three trades fail, will our trader be unlucky enough to experience an overall loss.
Another very effective risk management method is to limit the number of trades per month: you cannot lose money if you are not trading!
It is recommended that you limit your trades to no more than six per month. Combined with the above positive risk to reward ratio of 3:1, you will only need a minimum of two winning trades each month to remain profitable.
It is not the number of times you trade, but the quality of your trades that matter. Once you have a well-tested, well-proven, reliable trading plan, you can gradually increase your trading risk and increase the corresponding profit, whilst continuing to follow your trading plan rules.
Never risk more than 1% of your total capital on any single trade: the 1% rule should never be breached.
The increments of foreign exchange price chart movements are measured in pips. This unit name variously stands for: ‘Percentage In Point’, ‘Point In Percentage’ and ‘Price Interest Point’. A pip is the smallest price move that a given exchange rate makes based on market convention.
Assume that you have a trading capital of £100,000. At 1%, the maximum risk per trade is £1,000. Assume also that each trade has a risk of 20 pips. A stake of £1,000 divided by 20 pips equals £50 per pip.
Should a trade fail, your capital will only be reduced to 99%. Your risk capital is now 1% of £99,000 which equals £990. Your next trade will only need to make back 1.01% to recoup your loss. You will only need to make back 20.3 pips (£1,004.85) to reclaim your original principle – a very achievable goal.
Had you risked 10% of your original capital on a trade that failed, your capital is now reduced to 90%. Your risk capital is now 1% of £90,000 which equals £900. Your next trade will need to make back 1.12% to recoup your loss. You will now need to make back 222.3 pips (£10,003.50) to recover your original principle – a much more difficult challenge.
By rigidly following the guidelines and implementing effective risk management strategies, a trader can easily and reliably create order out of chaos, and safely navigate the flow of the foreign exchange markets.
There are advantages and disadvantages to every wealth creating strategy. To put off your long-term retirement plans and to leave them to chance, is a considerably riskier endeavour than finding an effective income source.