Forex School – 3rd Lesson
Risk Management – Theory
In many places, on the internet try to explain the foundations of the risk management with complex mathematical formulas. This often deters beginner traders who start trading without understanding the point of the risk management. With the help of the next simple examples, you can easily understand why risk management is so important in trading.
Joe buys share, because he trusts in that the price of share will rise. This happens, the price of share start rising.
– Yeah, I win! I sell quickly the share and so I will gain a little profit. – Think Joe and after he sells the share and very happy that he has 0,5% profit.
The next day, Joe buys share again, but the price starts to fall. Joe a little scares, but hopes that the price of share is going to rise soon. However, this does not happen, the price of share is continuously falling. Joe starts panic, but then begins to hope. Thinks that he still waits that the price will rise again and closes position with a little profit. Joe waits vainly. The price just falls and falls. When the share worths just the half of its purchase value, then Joe decides sadly that he doesn’t wait until he loses all his money rather sells his share with huge loss.
Joe buyed shares 2 times. The first time he gained profit, but the second time he lost. To sum up, he lost half of his capital. Where is the mistake in Joe’s logic? In the profitable situation he doesn’t take the risk, but in the loss situation he does. This is the worst that a trader can do. Those who trade like this, surely lose in the long run. This has to be done inversely.
The principle of Risk Management
After position opening, if the price is going into the good direction, then risk has to be taken and profit has to be maximized. After position opening, if the price is going into the wrong direction, then risk has to be avoided and position has to be closed within a short time, with small loss. The professional trader tries to gain more and more in profitable situation, however, in loss situation tries to lose as few as possible. This is the point of the risk management and at the same time the most important principle of the online forex.
Risk Management – Practice
Nobody sees in advance that what is going to happen in the market. Every trader makes wrong decisions. On the market, the consequence of the mistake is the loss. Professional trader knows it, because of this prepares in advance to control hard situations. The most important target of the risk management is to protect capital.
Common mistake that in loss situation the trader just waits and waits, while his loss continuously increases. Many investors lose all their capital in this way. During trading, always apply stop loss order, because it protects you from the greater losses. With the help of stop loss order, the price level can be set in advance where the system closes the position automatically. When entering the market, before opening position, you have to know exactly that how many pecentage of your capital are you willing to risk. The risk measurement that can be undertaken, depends on which time frame do you trade.
If you trade on the minute or 5 minutes charts, then can risk max 1% of your capital.
If you trade on the 15 minutes or 1 hour charts, then can risk max 1,5% of your capital.
If you trade on the 4 hours or daily charts, then can risk max 2% of your capital.
Common mistake that in profitable situations trader closes position too quickly. Thus, doesn’t get those income that he would have received. With the help of take profit order, the trader can realize his/her profit. The take profit order automatically closes the position if the price reaches a certain level. The target of the trader is the profit itself. It can be said from the profit, that the more you have, the better for you. So, take profit level, in case of professional traders, is not a fix value, can be modified during trading. This belongs to the theme of position building.
The determination of the optimal risk/reward ratio is an important point of the risk management. The most important rule is that the expected profit always be greater than the undertaken risk. This rule is the basis of the profitable trading.
Minimum risk/reward ratios of the positions:
If you trade on the minute or 5 minutes charts, then the minimum risk/reward ratio is: 1 : 1,25
If you trade on the 15 minutes or 1 hour charts, then the minimum risk/reward ratio is: 1 : 1,5
If you trade on the 4 hours or daily charts, then the minimum risk/reward ratio is: 1 : 2
When, for example, you trade on a 4 hours chart and risk $100, then the expected profit should be at least $200.