Basic Rules for a Proper Risk Management

Of course no one likes to lose money under any circumstance, but losses are inevitable in trading and that is why we need some rules to keep them controlled at all times. Therefore we include the following basic rules of risk management:

1. Do not risk more than 1% on each trade. This will give you a chance to survive a series of losses (draw downs) without affecting your account too much. We must bear in mind that what makes a trader wins in Forex and other financial markets at the long-term are the accumulated earnings of all winning trades so we must begin limiting the losing trades.

We will talk later about what technical features must have a successful trading system, but the point is that we must find or develop a model with a high percentage of effectiveness (Win Rate), so that the amount of points earned will become greater than the amount of points lost at the long term.

An active trader should risk less for each trade than a trader who make a few transactions per month.  Obviously, if you make 15 transactions a day, you cannot  risk more than 1% on each trade, because on a bad day you will experience a severe Drawdown.

If we trade a few times a month, then we can risk a little over 1%, but we must not risk much more because in this type of trades we surely will try to obtain profits of 2-5% per transaction, which once combined will give us a good capital growth. No matter how effective is a trading system over time, we must never significantly increase the maximum risk in any trade, as an anomalous and unexpected situation in the markets can disappear our trading capital.

Remember that very often the market is unpredictable.

But what happens when there are several losing trades in a row? We can have an excellent system that provides in 10 trades, 6 winners and 4 losers. But it is very difficult to know which of these 10 trades will be the winners and which losers. What if there are 4 consecutive losing trades?

What happens when we have successive losses?

At this point most traders tend to increase leverage in order to recover the loss thus far suffered, and they assume that the way to recover the money is to increase the risk. I wonder: If at that time these traders suffered a certain amount of losing trades, what ensures them that taking a higher risk will increase the earnings and then reduce the losses? Usually the opposite happens.

This is the reason why every trader should check and fix the percentage of capital that he/she will risk on each trade, in order to survive in consecutive losses.

2. Think in terms of percentages and PIPs, and not money. This allows the traders to abstract from the fact that he is working with capital. It is important to develop an statistical mind which continually compares the real results with those obtained in the tests and project realistic targets based on past results. These are management tasks that we would do in any other business, so, why not apply these principles in trading too? At the end is a business that requires management.

The Money management is closely linked with the statistics of our trading system. If we have a system with a high percentage of effectiveness, but without risk limit per transaction, our system will fail sooner or later, even against  other with a low probability of success but with established risk limits.

The money management works if we have a tested trading system in which we know the ratios of reliability and average gains and losses.

This is carried out under strict planning and risk assessment, which begins with a study of behavior of the system (backtesting), used to check the historical result of its application in the past and its probability of success in the future. This statistical base gives us a positive mathematical expectation which basically is the effectiveness of the system.

In the Trading Models section (it will be developed soon), we will learn about the more important statistics for professional traders. For the 1% rule we assume that our trading method has a long-term positive probability. However, the more risk a trader in each trade,  the higher has to be the reliability of the system. For example, if we risk 10% for each trade,  probably we are going to need a system with more than 90% of reliability, which is in practice impossible.

Often, the trading strategies with 80% accuracy, in the end have a chance of long-term success of 60% under real conditions. This means losing 4 out of 10 trades . It is imperative to control risk if we lose 40% of the time, but it is also true that only a 60% chance of success and a solid money management gives very good results. With this ratio of profit/loss, if we have experienced 4 losses in a row,  there are great chances of winning in the next trade and recover a good portion of the lost capital.

3. Minimizes the risk of open positions. In the event that all our open positions in the market cause losses, we surely wants to limit these losses to a low percentage of the total balance. We must be sure that the assets that we are trading are not too correlated, which in fact is equivalent to have a higher position.

The Drawdown should be the result of risk involved in multiple trades open, but not the product of a single big trade which has become a losing operation. This shows that to limit the Draw Down we must set a limit. But what is the optimal level of risk?

In this case, it is worth checking the simulations of coin tosses in with there is a chance of success of 50% in each coin toss. In these simulations, the player A with a 30% risk of capital was able to get a very similar performance compared to the player B with a 60% risk of capital. But with the advantage that the probability of ruin of player A was lower and the performance curve is less volatile than the player B.

4. Move the Stop Loss to the entry point (Break Even) when the position has moved substantially or at least as many pips as we were willing to risk when we open the position. It’s a good idea to liquidate the position in parts to ensure benefits frequently. Also, we can move the stop to the entry point, while we take some of the benefits, as this will help us to cover losses statistically.

There is a widespread belief that says that the beginners must pay to the market for their mistakes, and that losing the first accounts is the price of learning. Throwing money at the market will not make you more professional. However, if we risk 1% on each trade, it is most likely that we are going to survive long enough to prosper. In contrast, more severe losses not only can leave the trader in a situation of under-capitalization, but also in an emotional state of fear of losing again.

We must think that if we have 1000 US dollars in our trading account with a broker, in fact this is a potential sum of 100000 dollars within a few years. If you risk this money without following the money management rules, it’s like you’re burning 100000 dollars for your future. This brings us to the next rule:

5. Divide your positions to reach Break Even. Why stop loss are so vulnerable? Why the price is always threatening the stop loss? Maybe and image serves to illustrate the noise that the price has in a 30-minute intraday chart compared with the same period in a daily chart.
Risk management example
30 Minutes Price Chart


1 day  price chart for EUR/USD

Here is a practical solution to trade with very limited stops, based on a money management technique: fragment the position in several transactions (trades).The movements look pretty clean in a large chart but actually hides a far more chaotic behavior in charts with lower time frames . Imagine a typical 30 pips stop, and the chances you have of getting profit with a long-term trend. It is frankly difficult, right?

If we have a 30 pip stop loss is not so hard to get reach other 30 pips, if we follows a system minimally tested. If the price moves 30 pips in our favor, we can close half the position to stay at Break Even. This means that if the price at the end reaches the stop loss, we will lose as much as we had won, falling to zero, but with no losses.

Remember: a closed position in zero can be considered a gain. Why we say this? Imagine a system with a positive probability of only 52%. That means the rest, the other 48% are losing positions, right? !No! There are also the Break Even possibility. If the same system has a 15% Breakevens, that means that 48% are reduced to 33%. Reliability of 52% positive versus negative reliability of 33% implies a fairly good ratio.

The typical anxiety of not knowing whether or not the stop loss will be reached by the price, disappears when the position comes to Break Even. From there, no matter what the market do and your mind will be fresher to really see what the market is doing.

Manage the position from the moment in which half position is closed with earnings is a joy, because you can not lose anything. We can manage the other half as we want. Personally I like to close quarter of a position on a intraday take profit objective and sometimes, if I see that there is a medium-long term take profit objective, I leave the last quarter to reach it.

The odds in the market are very slim as the price tends to have a variable behavior. However, if we trade with a good money management strategy, we can  can cover the small losses that we were accumulating with a good income at the long term.



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