Determining Forex Risk Management
Like A Professional
Most people who are introduced to the concept of trading for a living are enthralled by the notion that it may be possible to earn a living by trading financial markets from home. Immediately, a person is enraptured at the thought of having no boss, no set hours, and no office commute.
Another reality that never quite hits home, however, when a person first begins trading is the huge disadvantage a stay-at-home trader is facing in relation to a trader at a large firm and just how risky forex trading is.
Let's examine the work environment at a large trading firm. First of all, there will be a team of analysts who are pouring over an endless stream of incoming data in order to dissect the latest news developments that may move the market. And let the emphasis be on the fact that this is a team of analysts. Furthermore, this data is quite expensive. Large trading firms are paying tens of thousands of dollars each month for data.
Next, there are generally a team of traders taking order from the analysts, and taking positions in the market. Then, there is an entire division of risk management, making sure than no traders are abusing risk parameters, and the risk management team is tracking individual and corporate daily Profit and Loss. This trading environment is quite different from the trading environment that you face as a stay-at-home trader. You have no analysts, no risk management team. You may have a supportive group at an online forex website, but for the most part, you are everything.
The Expectancy Formula
In order to find lasting success as a trader, it is absolutely imperative that you approach trading with the same degree of professionalism as a large trading firm. In this article, we are going to focus on risk management and how to establish risk parameters the same way a professional does.
First of all, you must determine whether your strategy has positive expectancy. Here are few questions to consider as you continue reading this article:
- Do you know the average win/loss percentage of your strategy? (not a guess, but an statistic that you have determined through historical analysis. Keep in mind that historical results are not necessarily indicative of future return but if your strategy fails to perform historically it seems unlikely that you will be able to reach any success in the future)
- Do you know your average dollar win on a winning trade and your average dollar loss on a losing trade?
If you do not know the answers to these two questions you cannot determine expectancy, and your probability of long-term trading success is significantly decreased.
Expectancy = (probability of win X average win) - (probability of loss X average loss)
Determining the expectancy of your strategy is absolutely essential. This is how you develop your risk management approach to trading. The retail trading world is inundated with false information, and one of the leading pieces of false information is that you should simply risk 2% per trade. This is the extent of risk management for most people, and this is a major mistake. Do you honestly think any hedge funds or large trading firms simply risk 2% per trade and call it a day?!!
Develop Risk Management Strategy
By plugging numbers into the formula above, you will notice that a trader can make money with all sorts of money management approaches. A trader can have a winning percentage of only 30%, but as long as the average winner is substantially higher than the average loser, then he can make money over the long-term in a forex trading demo and in a real account.
If you have not taken this step yet, begin to establish strict risk management parameters for your strategy by determining the variables listed above. When determining your risk level you need to consider your tolerance for risk and remember that OTC currency trading is risky. If you establish a risk management strategy, your trading will most likely go to another level as you take a huge step away from emotional trading, and a further step toward, objective, scientific trading.
-Article by Forextraders.com-