What is Risk Management?

This section is one of the most important sections you will ever read about trading. Why is it important? Well, we are in the business of making money, and in order to make money we have to learn how to manage risk (potential losses). Ironically, this is one of the most overlooked areas in trading. Many traders are just anxious to get right into trading with no regard for their total account size. They simply determine how much they can stomach to lose in a single trade and hit the "trade" button. There's a term for this type of investing....it's called...

GAMBLING!

When you trade without money management rules, you are in fact gambling. You are not looking at the long term return on your investment. Instead you are only looking for that "jackpot". Money management rules will not only protect you but they can make you very profitable in the long run. If you don't believe us, and you think that "gambling" is the way to get rich, then consider this example: People go to Las Vegas all the time to gamble their money in hopes of winning a big jackpot, and in fact, many people do win. So how in the world are casinos still making money if many individuals are winning jackpots? The answer is that while even though people win jackpots, in the long run, casinos are still profitable because they rake in more money from the people that don't win. That is where the term "the house always wins" comes from. The truth is that casinos are just very rich statisticians. They know that in the long run, they will be the ones making the money--not the gamblers. Even if Joe Schmoe wins $100,000 jackpot in a slot machine, the casinos know that there will be hundreds of other gamblers who WON'T win that jackpot and the money will go right back in their pockets. This is a classic example of how statisticians make money over gamblers. Even though both lose money, the statistician, or casino in this case, knows how to control its losses. Essentially, this is how money management works. If you learn how to control your losses, you will have a chance at being profitable.

In the end, Forex trading is a numbers game, meaning you have to tilt every little factor in your favor as much as you can. In casinos, the house edge is sometimes only 5% above that of the player. But that 5% is the difference between being a winner and being a loser. You want to be the rich statistician and NOT the gambler because, in the long run, you want to "always be the winner." So how do you become this rich statistician instead of a loser?

Capitalization

It takes money to make money. Everyone knows that, but how much does one need to get started in trading? The answer largely depends on how you are going to approach your new start-up business. First, consider how you are going to be educated. There are many different approaches in learning how to trade: classes, mentors, on your own, or any combination of the three. While there are many classes and mentors out there willing to teach forex trading, most will charge a fee. The benefit of this route is that a well-taught class or great mentor can significantly shorten your learning curve and get you on your way to profitability in a much shorter amount of time compared to doing everything yourself. The downside is the upfront cost for these programs, which can range from a few hundred to a few thousand dollars, depending on which program you go with. For many of those new to trading, the resources (cash money) required to purchase these programs are not available. For those of you unable or unwilling to pony up the cash for education, the good news is that most of the information you need to get started can be found for FREE on the internet

through forums, brokers, articles and websites like BabyPips.com. We should all thank Al Gore for inventing the Internet. Without him, there would be no BabyPips.com. As long as you are disciplined and laser-focused on learning the markets, your chances of success increase exponentially. You have to be a gung ho student. If not, you'll end up in the poor house. Second, is your approach to the markets going to require special tools such as news feeds or charting software? As a technical trader, most of the charting packages that come with your broker's trading platform are sufficient (and some are actually quite good). For those who need special indicators or better functionality, higher-end charting software can start at around $100 per month. Maybe you're a fundamental trader and you need the news the millisecond it is released, or even before it happens (wouldn't that be nice!). Well, instantaneous and accurate news feeds run from a few hundred to a few thousand dollars per month. Again, you can get a complimentary news feed from your broker, but for some, that extra second or two can be the difference between a profitable or unprofitable trade. Finally, you need money/capital/funds to trade. Retail brokers offer minimum account deposits as low as $25, but that doesn't mean you should enter immediately! This is a capitalization mistake, which often leads to failure. Losses are part of the game, and you need to have enough capital to weather these losses. So how much capital do you need? Let's be honest here, if you're consistent and you practice proper money management techniques, then you can probably start off with $50k to $100k in trading capital. It's common knowledge that most businesses fail due to undercapitalization, which is especially true in the forex trading business. So if you are unable to start with a large amount that you can afford to lose, be patient, save up and learn to trade the right way until you are financially ready.

Don't Lose Your Shirt

Here is a little illustration that will show you the difference between risking a small percentage of your capital compared to risking a higher percentage.

Trader Risks 2% vs. 10% on Each Trade

Trade Total # Account 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 $20,000 $19,600 $19,208 $18,824 $18,447 $18,078 $17,717 $17,363 $17,015 $16,675 $16,341 $16,015 $15,694 $15,380 $15,073 $14,771 $14,476 $14,186 $13,903 2% risk Trade Total on each # Account trade $400 $20,000 1 $392 $18,000 2 $384 $16,200 3 $376 $14,580 4 $369 $13,122 5 $362 $11,810 6 $354 $10,629 7 $347 $9,566 8 $340 $8,609 9 $333 $7,748 10 $327 $6,974 11 $320 $6,276 12 $314 $5,649 13 $308 $5,084 14 $301 $4,575 15 $295 $4,118 16 $290 $3,706 17 $284 $3,335 18 $278 $3,002 19 10% risk on each trade $2,000 $1,800 $1,620 $1,458 $1,312 $1,181 $1,063 $957 $861 $775 $697 $628 $565 $508 $458 $412 $371 $334 $300

You can see that there is a big difference between risking 2% of your account compared to risking 10% of your account on a single trade. If you happened to go through a losing streak and lost only 19 trades in a row, you would've went from starting with $20,000 to having only $3,002 left if you risked 10% on each trade. You would've lost over 85% of your account! If you risked only 2% you would've still had $13,903 which is only a 30% loss of your total account. Of course, the last thing we want to do is to lose 19 trades in a row, but even if you only lost 5 trades in a row, look at the difference between risking 2% and 10%. If you risked 2% you would still have $18,447. If you risked 10% you would only have $13,122. That's less than what you would've had even if you lost all 19 trades and risked only 2% of your account! The point of this illustration is that you want to setup your money management rules so that when you do have a drawdown period, you will still have enough capital to stay in the game. Can you imagine if you lost 85% of your account?!! You would have to make 566% on what you are left with in order to get back to break even. Trust us, you do NOT want to be in that position. You'd start looking a lot like Cyclopip. Do you wanna look like Cyclopip? Didn't think so! here is a chart that will illustrate what percentage you would have to make to breakeven if you were to lose a certain percentage of your account. Loss of Capital 10% 20% 30% 40% 50% 60% 70% 80% 90% % Required to get back to breakeven 11% 25% 43% 67% 100% 150% 233% 400% 900%

You can see that the more you lose, the harder it is to make it back to your original account size. This is all the more reason that you should do everything you can to PROTECT your account. By now, we hope you have gotten it drilled in your head that you should only risk a small percentage of your account in each trade so that you can survive your losing streaks and also to avoid a large drawdown in your account. Remember, you want to be the casino... NOT the gambler!

Drawdown and Maximum Drawdown

So we know that money management will make us money in the long run, but now we'd like to show you the other side of things. What would happen if you didn't use money management rules? Consider this example: Let's say you have a $100,000 and you lose $50,000. What percentage of your account have you lost? The answer is 50%. Simple enough. This is what traders call a drawdown. A drawdown is the reduction of one's capital after a series of losing trades. This is normally calculated by getting the difference between a relative peak in equity capital minus a relative trough. Traders normally note this down as a percentage of their trading account.

Losing Streak

In trading, we are always looking for an edge. That is the whole reason why traders develop systems. A trading system that is 70% profitable sounds like a very good edge to have. But just because your trading system is 70% profitable, does that mean for every 100 trades you make, you will win 7 out of every 10? Not necessarily! How do you know which 70 out of those 100 trades will be winners? The answer is that you don't. You could lose the first 30 trades in a row and win the remaining 70. That would still give you a 70% profitable system, but you have to ask yourself, "Would you still be in the game if you lost 30 trades in a row?" This is why money management is so important. No matter what system you use, you will eventually have a losing streak. Even professional poker players who make their living through poker go through horrible losing streaks, and yet they still end up profitable.

The reason is that the good poker players practice money management because they know that they will not win every tournament they play. Instead, they only risk a small percentage of their total bankroll so that they can survive those losing streaks. This is what you must do as a trader. Drawdowns are part of trading. The key to being a successful trader is coming up with trading plan that enables you to withstand these periods of large losses. And part of your trading plan is having risk management rules in place. Only risk a small percentage of your "trading bankroll" so that you can survive your losing streaks. Remember that if you practice strict money management rules, you will become the casino and in the long run, "you will always win." In the next section, we will illustrate what happens when you use proper money management and when you don't.

Reward-to-Risk Ratio

Another way you can increase your chances of profitability is to trade when you have the potential to make 3 times more than you are risking. If you give yourself a 3:1 reward-to-risk ratio, you have a significantly greater chance of ending up profitable in the long run. Take a look at this chart as an example:

10 Trades 1 2 3 4 5 6 7 8 9 10 Total

Loss $1,000 $1,000

Win $3,000 $3,000

$1,000 $3,000 $1,000 $3,000 $1,000 $5,000 $3,000 $15,000

In this example, you can see that even if you only won 50% of your trades, you would still make a profit of $10,000. Just remember that whenever you trade with a good risk to reward ratio, your chances of being profitable are much greater even if you have a lower win percentage. BUT... And this is a big one, like Jennifer Lopez's behind... setting large reward-to-risk ratio comes at a price. On the very surface, the concept of putting a high reward-to-risk ratio sounds good, but think about how it applies in actual trade scenarios. Let's say you are a scalper and you only wish to risk 3 pips. Using a 3:1 reward to risk ratio, this means you need to get 9 pips. Right off the bat, the odds are against you because you have to pay the spread. If your broker offered a 2 pip spread on EUR/USD, you'll have to gain 11 pips instead, forcing you to take a difficult 4:1 reward to risk ratio. Considering the exchange rate of EUR/USD could move 3 pips up and down within a few seconds, you would be stopped out faster than you can say "Uncle!" If you were to reduce your position size, then you could widen your stop to maintain your desired reward/risk ratio. Now, if you increased the pips you wanted to risk to 50, you would need to gain 153 pips. By doing this, you are able to bring your reward-to-risk ratio somewhere nearer to your desired 3:1. Not so bad anymore, right? In the real world, reward-to-risk ratios aren't set in stone. They must be adjusted depending on the time frame, market environment, and your entry/exit points. A position trade could have a reward-to-risk ratio as high as 10:1 while a scalper could go for as little as 0.7:1. If you want a real world example of traders trying to maximize reward-to-risk ratios, you should check out Pipcrawler's Pick of the Day blog and Cyclopip's Weekly Winner. Pipcrawler normally takes trade setups that have at least 2:1 ratios, while Cyclopip pinpoints the best setups from the previous week that would have maximized his profits.

Summary: Risk Management

Be the casino, not the gambler! Remember, casinos are just very rich statisticians! It takes money to make money. Everyone knows that, but how much does one need to get started in trading? The answer largely depends on how you are going to approach your new trading business. It varies person to person. Drawdowns are a reality and WILL happen to you at some point. The more you lose, the harder it is to make it back to your original account size. This is all the more reason that you should do everything you can to protect your account. We hope that you have gotten it drilled in your head that you should only risk a small percentage of your account in each trade so that you can survive your losing streaks and also to avoid a large drawdown in your account. The less you risk in a trade, the less your maximum drawdown will be. The more you lose in your account, the harder it is to make it back to breakeven. This means you should only trade only a small percentage of your account. The smaller the better.

Less is more.

2% or less is recommended.
Although it is desirable to trade with a high reward to risk ratio, it comes with a drawback. In the real world, reward-to-risk ratio's aren't set in stone. They must be adjusted depending on the time frame, market environment, and your entry/exit points.