Tuesday, June 19, 2007

Understanding Forex Risk

In this article I want to deal with the mechanics of how to calculate your risk. I have a free indicator that will allow you to calculate risk dynamically before each trade is placed. Please download it and install it in your MT4 indicators folder, and load it on any chart.


Any system can take a string of losses. I have a video on trading cycles that illustrates the point. The idea of risk management is to be able to take a string of losses, and and survive.


Consider this equation:
Account size (times) Risk Percent (divided by) Stop Level.


So for example, if your account size is $10,000 and you want to risk 5% per trade and you have a 40 pip stop, the equation would look like this:


( $10,000 x 0.05 = $500 ) / 40 = 12.5


This means you would be trading a lot size of 125,000 k and 1 pip represents
$12.50


If you get stopped out at 40 pips your total loss would be $500


let me break this down further.


First we calculate 5% of our account using multiplication. 0.05 represents 5%. If you wanted to calculate 3% you would multiply your account size by 0.03. Once we have that total, we divide it by the stop size for each trade.



  1. Account size is $10,000

  2. We want to risk 3%

  3. $10,000 x 0.03 = $300

  4. So 3% of our account size is $300

  5. To make sure we never lose more than $300 we divide it by our stop

  6. In this case our stop will be 40 pips.

  7. $300 / 40 pips = $7.5

  8. So we should open a trade that represents $7.5 per pip


Dynamic Risk Levels



It is important to remember that each trade may have a different stop level. It is therefore not sufficient to calculate your risk level and apply this to every trade. For example, adopting the risk level above, you trade $7.5 per pip. If you were to change your stop to 60 pips and take a loss, it would equal $450 which means you actually risked around 4.5% on that trade not 3%.



The indicator you downloaded from forex signal live will allow you to quickly and easily change the stop levels for each trade, and it will dynamically update as your account size changes.

The Usual Warnings


No discussion about risk would be complete without the usual warnings.


I personally consider 5% too high: Let's assume we take 5 losses in a row on our $10,000 account. That is 5 x 500 = $2,500. You have just got started and your account size is now reduced by 25%! Ouch!


Of course I'm not accounting for winning trades, but assuming the worse case scenario. Now let's assume that you lost your sanity, and started trading at 10% risk. It only seems like a small 5% increase, but if you take 5 losses in a row you lose $5000. That is half your account.
Very Ouch!


At the 3% level, I could ride 34 losses, before I lost my account. I think I could do better than that with a coin toss. At the 10% level you would be out of business in 10 trades.


It is easy to think that this is not realistic, because you will have winning trades as well. It's easy to focus on the potential gain that 10% risk will give you. Even the best of traders have taken strings of losses. There are old traders, and there are bold traders, but there are no old bold traders.


So take my advice and start small, move your risk higher as you get more confident. I recommend that everyone starts at 1%.


- Mark

Mark Rayner is the head trader at Forex Signal Live (http://www.forexsignallive.com/) - Join him as he delivers trading signals and good advice.

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