Risk Management 

Risk management is key to your successful trading. Master it! Good traders never risk more than 1-3% of their well-financed capital on any one position. 1% is a much better risk level. With a larger account, you have more freedom to take smaller risks (up to 3%), and still make money on your trade. With a smaller trading account, you generally have to risk more for any trade to be worth your while. If you're starting with minimal capital (say $2K), the rule of thumb is never to risk more than 5% of your capital on any one position. With an initial capital of $2K, you can risk up to $100 (5% x $2000) on any one open position. That means, the most you can lose in one trade is $100.

Eg. Capital $2K

If you're trading in a mini lot where the value of one pip for say, the currency pair EUR/USD is $1, the most you can lose on a $2K account is 100 pips (1pip x $1 x 100 = $100). That means the market needs to move 100 pips against you in order to move you out of the game.

If you're trading a standard lot where the value of one pip for the same pair is $10, your maximal loss would be 10 pips (1 pip x $10 x 10 = $100). That means the currency pair will need to move JUST 10 pips against you and you're out.

The larger your account balance, and the minimal the risk, the more your chances of survival in the markets. Having a large account balance while trading with minimal risk also has a positive psychological effect. For example, if you know that the most you’ll lose on your $10,000 account is $200 on any one trade (2% risk), that decreases and relieves an enormous amount of anxiety for you.

If you've lost a certain predetermined amount of your initial capital, stop trading, analyze what went wrong, and wait until you feel confident to trade again.

When considering risk management, consider these 2 levels:

1. Risk per currency pair (see volatility of each pair below)
2. Risk % of your trading account (see example above)

Utilize these parameters and you will find yourself assessing risk like a pro.

Stop-Loss

The number one decision when entering a trade is to know where you are going to get out if the market goes against you. This means setting stops ahead of time and changing them when its appropriate to do so.

Your decide where your stop-loss is before you enter a trade. A stop-loss works like an insurance against your trading account backruptcy. If you have picked the wrong trade or if the market didn't go the way you thought it would, because you have placed a stop-loss, your loss is limited. You would prevent losing your entire trading account in just a few of trades, and still have enough for making up your lost trades later. The disadvantage is that locals and market makers can "hunt" for your stop.

Advantages of Placing Stops

1. Mentally preparing for the worst.
2. Decision more likely to be made with a more balanced judgment.
3. A correctly placed stop is usually executed at a better price.

How do you place a stop-loss?

If a channel has formed or price is in a congested area, a good area to place a protective stop is just outside of the support or resistance boundary that makes up the trading channel or congestion area. For instance, if price is nearing the upper boundary of that channel, and the trader anticipates a bounce from that resistance level, he or she would place a protective buy stop just above the resistance level of the trading channel and initiate a sell position. In contrast, if price is nearing the lower boundary or support level, the trader would place a protective sell stop just below the support level and initiate a buy position.

If the market is in an uptrend, and you want to initiate a buy position, your stop-loss would be at a few pips below the previous swing low. If the market is in a downtrend and you want to initiate a sell position, your stop stop-loss would be at a few pips above the previous swing high. How many pips you would consider for your protective stops really depends on the currency pairs you trade, and your holding period.

Do not place stop-losses at obvious rounder numbers (00,10, 20, 25, 50, 75, 100). Put S/L below them for long positions, and above them for short positions.

Best places to enter a Stop-Loss for LONG Positions:

1. Below a previous low
2. Below the extreme low of an emotional bar (eg. a pin bar)
3. Below an up trendline (below support)
4. Below a reliable MA (eg. 50 EMA)
5. On a breakout from a price pattern
6. When more than one of these conditons are met is a better bet

Best places to enter a Stop-Loss for SELL positions:

1. Above a previous high.
2. Above the extreme high of an emotional bar
3. Above a down trendline (above resistance)
4. Above a reliable MA
5. On a breakout from a price pattern
6. When more than one of these conditions are met is a better bet.

Do not put your stops AT support or resistance.

Considerations when Placing Stop-Losses

1) Volatility of Each Pair

To consider how much stop-loss you need, you have to take into account that different currency pairs have different levels of volatility. Some currency pairs commonly shoot up (or down) as much as 300 pips in a single day, while others generally move 50 - 100 pips.

Take AUD/USD and GBP/JPY for example. Because AUD/USD has a narrower range, you may place a 100pips S/L, while for GBP/JPY, because of its double volatility to AUD/USD, you may place a 200pips S/L.

Example

- $5K trading account
- 5% risk (risk would be the difference between your entry and your stop level)

The amount you would be willing to risk here would be $250 (5K*5%).

If you decide to open a position on AUD/USD with a stop-loss of 100pips, then you can buy two mini lots of AUD/USD and stay within that risk: (0.1+0.1x100 = $200)

If you decide to open a position on GBP/JPY with a stop-loss of 200pips, you can buy only one mini lot to stay within your risk threshold (0.1x200 = $200).

2) Time Frame/Holding Period

The smaller your time frame, the smaller your stop-loss should be. The longer the time-frame, the wider the stop-loss. The size of profit objective and stop-loss will be proportional to the length of your holding period - the shorter your time frame, the smaller your profit target and stop-loss should be; the longer the trading time frame, the wider your profit target and stop-loss can be.

Risk - Reward

Another form of risk management is calculating before a position is undertaken, the ratio of that risk compared to the reward you're expecting to gain from closing that position. For example, since you already know where you're going to place your stop-loss, which is say 10 pips from your entry, and you have targeted the next resistance level as your profit, which is 30 pips away, your risk/reward ratio would be 1:3. Divide the amount of profit you expect to make by the amount you expect to lose when your stop-loss is hit, and you get the ratio.

Most professional traders go by this decision when they open a trade. You can stick to a ratio of 1:2, 1:3, 1:4, and so on. The minimum recommended 1:3 - calculate the risk/reward ratio before putting a trade on. In Forex trading, 1:1 reward/risk trades are also possible in some instances, but only when they offer a higher probability of success, say 90+%.

The advantage to utilizing more than 1:1 risk/reward ratio on every trade, say 2 to 3 times risk or more on all your winning trades, you should be able to make money over a series of trades even if you lose the majority of the time.

On the chart below, a congestion on the 15mins EURUSD breaks down prompting a short entry with a target profit at the previous support level which is 20 pips away. At a S/L of 10 pips from the high of the last bar, the risk/reward ratio for this position would be 1:2. If price is expected to go further south which is the next support level at about 50 pips away, the risk/reward ratio would be 1:5 which is a very good risk/reward ratio and a risk worth taking. And so are the next targets 1:7 and 1:10.

If you are to take a long position in the occasion that price breaks out of the congestion, consider the risk/reward ratio then. Your first target which is the previous resistance level is about half of your S/L - definitely not a viable risk/reward ratio.

Once you have decided that the reward outweighs the risk, decide on how much money you should place on this trade (1-3% of capital). To summarize it all, the position you take on any one trade should be determined by:

1. account size
2. the perceived risk
3. proportion of your account you are willing to risk

Protect your Profits