Risk Management

Risk Management is one of the most important ingredients of successful trading. While it is emotionally more appealing to focus on the upside of trading, every trader should know precisely how much he is willing to lose on each trade before cutting losses, and how much he is willing to lose in his account before ceasing trading and re-evaluating. Risk will essentially be controlled in two ways: a. By exiting losing trades before losses exceed your pre-determined maximum tolerance (or "cutting losses"). b. By limiting the "leverage" or position size you trade for a given account size.

Cutting Losses

Too often, the beginning trader will be overly concerned about incurring losing trades. He therefore lets losses mount, with the "hope" that the market will turn around and the loss will turn into a gain.

Almost all successful trading strategies include a disciplined procedure for cutting losses. When a trader is down on a positions, many emotions often come into play, making it difficult to cut losses at the right level. The best practice is to decide where losses will be cut before a trade is even initiated. This will assure the trader of the maximum amount he can expect to lose on the trade.

The other key element of risk control is overall account risk. In other words, a trader should know before he begins his trading endeavor how much of his account he is willing to lose before ceasing trading and re-evaluating his strategy.

Determining Position Size

Before beginning any trading program, an assessment should be made of the maximum account loss that is likely to occur over time, per lot. For example, assume you have determined that your worse case loss on any trade is 30 pips. That translates into approximately $300 per $100,000 position size. Further assume that the $100,000 position size is equal to one lot. Five consecutive losing trades would result in a loss of $1,500 (5 x $300); a difficult period but not to be unexpected over the long run. For a $10,000 account trading one lot, this translates into a 15% loss. Therefore, even though it may be possible to trade 5 lots or more with a $10,000 account, this analysis suggests that the resulting "drawdown" would be too great (75% or more of the account value would be wiped out).

Any trader should have a sense of this maximum loss per lot, and then determine the amount he wishes to trade for a given account size that will yield tolerable drawdowns.