When we talk about “money management” or “risk management”, most people seem to think the discussion starts and finishes with “how much to risk per trade”. While thinking about how much money to risk on each trade is certainly part of the puzzle, it still doesn’t allow a trader to run a tight ship.

Hopefully this article will close that gap and help traders deploy their risk capital in a sound, professional manner.

Protect Your Risk Capital

I have personally spoken to traders that have lost their entire account, only to refill it and persevere – expecting a different outcome for some reason. So let’s make one thing crystal clear: once you calculate how much risk capital you will allocate to trading, that must be your final commitment. Do not throw more money into a trading endeavour that is not bearing any fruit.

How do you calculate how much risk capital to allocate to trading? That’s easy if you think about it logically:

  • it cannot be money you need for rent, bills or any other expense
  • it cannot be a part of your monthly paycheck
  • it cannot be money you were saving for a family vacation

You get the picture: it has to be money that would simply be sitting in a savings account doing nothing. It should be money that you can afford to lose, without changing your lifestyle one bit. That’s the nature of “risk capital”. It’s money you can actually afford to risk. Not all aspiring traders can truthfully say they are trading with risk capital. Trading is a tough job, where you’re up against other experienced professionals. Most aspiring traders lose 90% of their capital in 90 days. Be different. Be smarter.

So identify a sum you can afford to lose, and if you lose it you’re out of the game. Risk limits will not help you if you have no edge. Risk limits will “limit the damage” for sure, but it won’t keep you ahead of the game. Your education will determine your long-term odds, so as we’ve said time & time again, don’t risk real money until you have proof (on a demo) that your model actually has some kind of edge.

Risk Capital Allocation

So let’s imagine you’ve got AUD 10.000 to risk, and you have proven yourself on a demo account for at least 3 months. What’s the next step? Do you just open an account with a reputable broker, throw your entire pot into the account and put the pedal to the metal?

You may call me uber-conservative, but I believe there is a better way. I believe in deploying risk capital based on merit. Initially, deposit 10% of your risk capital with the broker. That would be AUD 1000 in our example. You will start trading with microlots most likely, but there are certain benefits:

  • you will be “almost” demo trading, because the amounts will initially be quite small, so psychological pressure will be minimal
  • you will still have 90% of your risk capital in the bank in case your broker defaults 

If, after the first month, your results are positive, you can bring another 10% into play during the second month hence increasing your bet size. I would say that you can do this even if you broke even during the first month of live trading. Refrain from adding to the account if you’re at a loss after the first month. For sure, revisit your model and try to understand what differences there are between the successful demo trading (which allowed you to progress onto live trading in the first place) and your first month of live trading. Using an independent trade journal service (TraderVue, FXStat, Myfxbook, etc) will help with this task.

The objective is to deploy your total risk allocation over the course of your first year of trading based on:

  • the amount of risk capital you possess (the larger it is, the more you can dilute it)
  • your trading results (only add if your trading is convincing)

The bottom line is that your account balance will grow alongside your experience level, and you give yourself more time to survive, trade and learn. It becomes increasingly difficult to run out of risk capital after a series of losing trades.

Risk per Trade vs. Risk per Day

Many aspiring traders are foreign to the concept of risk limits. They take their risk capital (AUD 10000), throw it into an account, divide it by 100 (AUD 100) and that’s their risk per trade. Risking a fixed 1% of your account is certainly better than having no plan at all, or betting 5-10% per trade (which of course will stack the odds of survival firmly against you). But this reasoning doesn’t insulate you from drawdowns or overtrading.

Traders generally underestimate the probability of an extended losing streak. In the chart above we have illustrated the probability of at least 1 occurrance of losing X times in a row over the next 10 trades. The excel formula utilized is:

= 1 – binomdist(0, A – B + 1, C^B, false)

with

A = n° of trades to consider (10 in our example)
B = n° of consecutive losses to evaluate
C = probability of loss in a single trial = 1 – %win

Now let’s put this into perspective.

If you’re a day trader and trade 10 times per day with a 50% hit rate, you can still expect to have 3 or 4 losses in a row. So if you risk 1% per trade,  it is logical to expect a 4% drawdown once every 3-4 days and a 3% drawdown most days. If you do not have a very robust mindset and model, it doesn’t take many of those ocurrances to deplete your risk capital.

I would therefore suggest reducing the amount of trades through a quality filter of some sort, and also decide on a maximum risk per day. So perhaps you would be better off risking 1% per day – not 1% per trade. If your trading model generates 3-5 trades a day, then you split your risk allocation into 3 or 5 and that means risking anywhere from 0.20% to 0.33% per trade. These are realistic numbers to work with.

You can then augment your exposure based on merit, for example risking 1% per day in the first month and if everything goes according to plan, raise it to 1.2% the next month, 1.4% on the third month, until you’re risking 2% per day after your first year of trading. I personally think it’s excessive but, like everything in trading, that would depend on your risk appetite, your experience level and your trading model.

The same logic would apply to swing traders which would perhaps consider a weekly risk limit. This is what I suggest to my coaching students, because they target 3-5 trades per week. I suggest starting with a risk limit of 2%-2.5% per week. That’s roughly 0.5% per trade.

Once again, as the experience level and confidence increases (based on tangible results) the weekly risk limit can be augmented but I would not really exceed 4-5% per week even in the most aggressive scenario.

Position traders can think in terms of monthly risk limits. Perhaps the first month they can start off risking 5% of their capital on the 1-4 trades that a position trading system generally offers. Once again, as the experience level and confidence increases (based on tangible results) the monthly risk limit can be augmented but I would not really exceed 20% per month even in the most aggressive scenario.

Over To You

Risk limits definitely help you control drawdowns and stay in the game longer than most.  Of course, we would all love to take “risk-free” trades but unfortunately that just doesn’t exist in real life. You need to risk money to make money – so simply make sure the risk is well worth the potential reward.

By adhering to strict risk limits, you will be able to withstand losing streaks, contain drawdowns and ultimately manage your downside like a professional. This will put you ahead of most retail traders out there and enhance your chances of long-term survival.

About the Author

Justin is a Forex trader and Coach. He is co-owner of www.fxrenew.com, a provider of Forex signals from ex-bank and hedge fund traders (get a free trial), or get FREE access to the Advanced Forex Course for Smart Traders. If you like his writing you can subscribe to the newsletter for free.