The Theory of Risk and Money Management
by
FX Robot Guide
Risk management is the theory of managing your trading risk to ensure that the trader is able to continue to trade through the inevitable bad times. There is nothing worse than having four consecutive losing trades, and then being on the right side of the market and have no trading capital left in your trading account to take advantage of it.
A strong risk management system could make or break the trader s success. Essentially, a trader with an average trading system, but a strong risk management system will most likely outperform a trader with a strong trading system and a poor or non-existent risk management system.
Trading risk management works on a similar principle as diversification in investment. Essentially, there are three areas to risk management:
1)Maximum loss per trade or stop loss
2)The ratio of expected win to expected loss win/loss ratio
3)Maximum market position Open position
When combined, these three factors combine to form the trader s risk management system, which will provide a positive edge in your trading.
A stop loss is an order that is placed, when a trade is entered, that will ensure you limit the trader s potential loss on the trade. For example, if you buy at 100 and position a stop loss order at 80, your maximum potential loss is 20.
Stop loss orders are useful for three specific reasons:
1)Once entered, the trader knows exactly how much money can be lost on any single trade
2)It prevents the trader from falling in love with a trade and running with it despite the market moving against the position
3)A stop loss allows you to monetise your risk management system
As can be seen, stop loss orders are an essential component of your risk management system.
The win / loss ratio is the key function of any risk management system. Essentially, it is the ratio of the expected win on a trade, to the expected loss on a trade. Graphically:
Expected win : Expected loss = win loss ratio
As an example, if a trader expects to win 100bps on a trade, and are willing to risk 50bps on the trade, the win/loss ratio is
100 : 50 = 2:1
This means that the trader is willing to risk one unit of loss for two units of gain.
Trade size is related to the context of the trading account and is a function of the stop loss that the trader is running on a trade. If the trading account happens to be worth $100,000 and the trader is willing to risk $5,000 on any one trade, the determined trade size is 5%.
Trade size works on the theory of risk to ruin. We all know that there is risk in trading and that there is also risk of consecutive trade loss. Risk to ruin is the concept that the trader will stop out of so many consecutive trades that there entire trading capital will be wiped out.
In the above example, with a 5% maximum trade size, the trader will need 20 consecutive losing trades to wipe out there entire trading capital. While this is not impossible, it is regarded statistically as highly unlikely.
Putting this all together, a simple risk management system might be something like:
Risk no more than 5% of the trading account on each position
Risk no more than 10% of the trading account in each asset or market
Do not take any trades that have a risk/reward ratio of better than 2:1
While simple, the key to this system is to ensure that the trader is aware of how their trading position sits with their risk management system at all times.
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