To achieve success in trading you have to know and follow three important steps.
- Protect your investment
- Make money
The first rule is to protect your investment, then you should think about making profits. After following these two rules, you have to repeat the step 1 and 2 frequently.
Risk management or money management is the method and strategy to protect the investment. It does not mean that money management guarantees a risk-free investing. There is always a risk in trading, but money management helps a trader to minimize his risk.
The more you lose the lesser money you have for the next opportunity. If you avoid money management then you will end up with the loss over the long run. There are some money management tools to reduce the risk. If you use money management in a proper way, then it will work as a guard for your investment.
Capitalization and Position Sizing:
You need money to trade, without investing any money you can not trade in reality. Now, how much money you should invest? It depends on a trader’s financial condition.
Some have the ability to invest below $10000 others might have the ability to invest a big amount of money for trading. It is suggested that a trader should not invest much that he can not afford to lose.
It is better to invest money that you can afford to lose. Do not invest that money which you need on a daily basis.
Position sizing is simply dividing a portfolio into smaller equal parts to diversify the investment and to reduce the risk. It increases the probability of winning and reduces the risk of loss.
For example, if you have invested $10000 and entered into a position with whole investment, then only 10% loss would be $1000 which is pretty high.
In this case, you have 50-50 chance to win or lose in the trade. Now, if you divide your investment into 5 equal parts then in each position you will involve $2000 only.
10% loss of this $2000 is only $200 which is 2% risk of the total investment. In this way, your chance of winning will be higher, and some winning trades will cover up some losing trades. This will lead your investment on the winning side.
After a series of losing a trader’s equity drops. This scenario is called drawdown. This drawdown will be calculated from the peak point of your equity.
Drawdown is part of trading. Every trader has to absorb drawdown as there is no certainty lies in financial markets. Successful traders do not worry about drawdown as they know that they would be able to cover up his drawdown.
In general, a good technical analysts or trader gets 7 winning trades and 3 losing trades out of 10 trades. This means if you make 10 trades then you have a chance to get profit in 7 trades and have a chance to lose in 3 trades.
In this case, you have 70% accuracy if you already know technical analysis or have a proper trading strategy.
This situation can give profit if you follow a risk management tool called stop loss. You have to minimize the risk, only then this 70% winning ratio will lead you to a good profit.
If your winning trade gives $100 and losing trade takes $50, and you have 70 % winning ratio then you will be in a good profit. Your profit in 7 winning trades would be, 7 x $100 = $700. Your loss in the rest of 3 losing trades would be, 3 x $50 = $150. So your profit is $700 – $150 = $550.
The risk of large loss can be eliminated by using stop loss, which is a part of money management or risk management. To be successful in trading a trader should minimize risk by using stop loss and position sizing.
Risk to Reward Ratio (R:R):
The risk to reward ratio explains how much risk you are willing to take to get a decent amount of profit. It is also known as R:R. If your profit is 3 times larger than your loss then your R:R is 1:3.
It is related to stop loss and take profit. If your stop loss is at 20 pips then your take profit target will be at 60 pips. So, your R:R = 20 pips : 60 pips =1:3.
There are many trading strategies which have 40 – 50% winning percentage. If your winning percentage is low then you have to use high R:R ratio to be on the winning side.
For example, you have 40% winning percentage. Which means you will win in 4 trades and will lose in 6 trades. Now if your profit per winning trade is $100 and loss per losing trade is also $100 and after 10 trades if you have 4 winning trades and 6 losing trades. Then,
Your profit from 4 winning trades is 4 x $100 = $400
Your loss from 6 losing trades is 7 x $100 =$700.
Your profit or loss is $400 – $700 = -$300
So, if you have 40% winning percentage with low R:R ratio then you will end up in a loss. There is no need to improve winning percentage if you use higher R:R ratio with the same winning percentage. If you had R:R = 1:3 with 40% winning percentage, then
Your profit for 4 winning trades would be 4 x $300 =$1200
Your loss for 6 losing trades would be 6 x $100 = $600
So your profit or loss would be $1200 – $600 = $600
A strategy with low winning ratio requires higher risk to reward ratio. On the other hand, a strategy with high winning ratio can give profit in low winning ratio.
Originally published at Forex Risk Management Strategies Explained