Most traders lose money, regardless of how intelligent and knowledgeable they are about the markets. The good news is that the problem can be solved through management techniques.
Two aspects of risk management are important. Risk a little to make a lot – use at least a 1:2 risk to reward ratio. Risk a small portion of your account – risk less than 5 per cent of your account on all open trades.
Use at least a 1:2 risk to reward ratio
DailyFX, a well known foreign exchange (forex) institute, published Traits of Successful Traders which concluded that most traders lose because they do not understand or adhere to good money management practices.
Part of money management is determining risk before placing a trade. Without a sense of money management, many traders hold on to losing positions far too long, but take profits on winning positions prematurely.
The result is all too common: the trader ends up having more winning trades than losing trades, but still loses money.
Establish your risk and reward parameters ahead of time. Insist on taking trades that offer at least a 1:2 risk to reward ratio. This means that for every pip of risk you are taking in the trade, seek out at least 2 pips of potential reward. By so doing, you are relieving the pressure from yourself to have to be right in the trade.
As James Stanley eloquently points out in his trading plan, you can be right only 50 per cent of the time when using a 1:2 risk to reward ratio to give yourself a shot at consistent returns.
Risk no more than 5 per cent
There is another element to consistent risk management. How much of your account are you risking?
Too often, I hear from clients via twitter or during our live webinars, that they are risking a small amount, just 20 pips on the trade. The true risk on the trade is how much of your account balance are you exposing?
Is it possible that Trader A can have a stop loss set at 10 pips and risk more than Trader B with a 50 pip stop loss? Yes!
As you can see from the above example, the trade size (and resulting cost per pip) multiplied by your stop distance determines your risk on the trade.
In our courses, we suggest risking no more than 5 per cent of your account balance on all open trades. That way, if you are wrong (and we established from the first key point that it is ok to be wrong 50 per cent of the time), then you still have over 95 per cent of your account balance available to trade tomorrow.
The formula to calculate risk on the trade is: Cost per pip X pip’s risked = account balance risked. For example, if I’m trading AUD/JPY with a current pip cost of $1.25 per 10k position, then a trade with 50 pips of risk is $62.50 risked in my account. ($1.25 X 50 pips = $62.50).
How to choose a forex strategy
Let us get started with the four-step checklist. In my opinion, a strategy is a good D-E-A-L if it can positively answer each element of this acronym: Description; Entry/Exit Signals; Application; and Leverage.
A positive result in the four items of the checklist is no guarantee the strategy will be profitable. Nobody knows what the market is going to give in the next minute, let alone the next day, week or month.
Therefore, the objective of the four-point checklist is to properly identify and implement a forex strategy by utilising appropriate leverage and performance expectations which results in higher probability trading.
Let’s unpack each element of this acronym.
Description
The first thing we should look at when considering an automated strategy is the description of the strategy. Find out what the strategy does and the general logic behind the strategy. Look for buzz words such as stop loss, profit target, risk to reward ratios, risk, breakout, trend, momentum, range.
By carefully reading the description, the first thing I want to identify is what type of market condition this strategy is intended to be used in. You see, strategies are designed to do well in only certain market environments. Strategies that can do well in all market environments are very difficult to come by.
Therefore, one way to bring realistic expectations is by determining what type of environment the strategy tends to do well in, and then apply that strategy to a market exhibiting the same condition.
Entry/exit signals
Many traders spend most of their time agonising over the strategy’s entry and exit signals. It is important to understand the general logic behind the strategy, but we do not want to over emphasise each trade the strategy makes.
This strategy will likely produce hundreds or thousands of trades. Therefore, it is the collection of trades generated by the strategy that we are interested in and not each individual trade.
Look at the trade performance as a basket of trades rather than based on each individual trade.
Ways of reviewing trades:
1. Place all of your winning trades in a basket and all of your losing trades in a basket. What is the average winner? What is the average loser? Seek strategies with higher average winners versus average losers.
2. Review the trade performance in baskets of 10 trades. Take a look at your last 10 trades, did the net result add pips to your account or take them away? Seek strategies that add pips in a basket of X trades.
Application
I mentioned above how we want to use the description to determine the market condition the strategy is designed to thrive in. Once we identify the market condition, we then seek out a market that exhibits that characteristic. This step is often overlooked by traders.
There are generally two different types of market conditions with several variations. Today, we are only going to concern ourselves regarding trending markets and non-trending markets (often times called ranges).
These two conditions are exclusive of each other. When the market is in a trend, prices are making progress. You will see a series of higher highs and higher lows in an uptrend and a series of lower highs and lower lows in a downtrend.
On the other hand, ranges form when the market is not making progress one way or the other as the market trades sideways. All we need to be concerned about is to identify in which type of condition our strategy ideally thrives and find a market that matches the same condition to trade this strategy.
Leverage
The last of the four-point checklist is leverage. This is another commonly overlooked area by automated forex traders. Many times, traders will generally utilise a good strategy, but they simply expect too much from it and therefore apply too much leverage.
This is generally caused because traders are looking at the upside to the strategy and not planning for any potential losses. To help keep your account capitalised through such drawdowns, it is important to use conservative amounts of leverage or none at all.
We suggest utilising no more than 10 times effective leverage. If you are a conservative trader, consider using even less leverage at five times or smaller. The benefit to using smaller amounts of leverage is that when your strategy experiences a drawdown, you are risking a small portion of your account and therefore would have more capital left to trade than if you used large amounts of leverage.
Participate in higher probability trading by incorporating the four point checklist above. This will help you properly identify and implement a forex automated strategy by utilising appropriate leverage and performance expectations.