The only thing that disturbs me is poor money management – Bruce Kovner
The best traders play great defence first.
They know that if they manage their risks properly, their “edge” will provide them with the opportunity to profit significantly in the long run.
But managing risk is much more complex than simply putting on a stop-loss and risking 1% of your account per trade. There are lots of ways to lose money in the market, so it’s wise to prepare for as many as you can.
This is why your trading plan should pay significant attention to these 5 critical risks:
Risk to core capital
If you don’t keep hold of your core trading capital, you will be out of the game – it’s as simple as that. If you are new, you need to remain in the game long enough for you to learn. If you are experienced, you need your core capital to achieve your trading goals.
Too many traders are all too happy to take big risks with their funds, instead of taking care of their core trading capital. Remember this: if you lose 50% of your core capital, you need to post a 100% return just to break even.
It’s important to realize that as a trader, you should avoid risking too much of your own money. Trade small, until you are in profit, and then increase your trade size once you have a buffer. For example, if you plan to risk 1 or 2% on your trades, start by risking 0.1 or 0.2% until you have some profits. Then, scale up your trade size to 0.3%. (Then 0.5, then 1, etc.)
This will protect your core capital, and there is no real excuse not to do it with the ready availability of Micro-lots these days. If you increase your position sizes incrementally, you can allow your edge to carry you into significant profit, with minimal risk to your core capital.
Counter-party risk is a fancy name for your bank or broker going bust. It happens a lot.
Brokers in FX are effectively trading organizations, as they are making markets. Most of them use cheap MT4 risk management technology, have poor lines of liquidity with the interbank market, and are not staffed with good traders. Many are also very thinly capitalised, with little ability to withstand a market shock.
(By the way, this applies to all brokers, not just market makers. Think about FXCM who recently almost went under, who bill themselves as an execution only broker. Don’t always believe what you hear on the surface.)
There are several strategies for managing counterparty risk that I will share in my upcoming “insider” report.
In the meantime, I suggest you use a number of brokers and keep only a small portion of your trading capital in your account.
News event risk
Often, your trading account will be subject to wild swings based on news announcements. This is particularly true in the golden age of the central banker (think of the swing around the innocuous FOMC comments last week).
The good thing is that because you know the event is coming up, you can plan ahead. Effective risk management around events means understanding what the risk(s) to your position(s) will be, coming into the event. Making sure that the worst-case scenario is handled (before it has a chance to surface) is paramount to effective risk management.
This might mean a combination of adjusting stops and purchasing option protection. It may also mean scaling out of part of your positon prior to the event, to limit the magnitude of potential losses.
Risk of SNB type gaps
Unlike event risk above, these gaps occur when you are not expecting them. Unexpected news that causes massive swings is a reality in the market, and must be considered.
To protect from this type of risk, you want to have limits on your positon size, or option protection if your position gets above a certain level. You also want to be very conscious of correlations. If you have several small positions that you don’t realise are correlated, then you could be in for a nasty shock when things turn to custard.
There are also some structures that retail traders can adopt with their accounts that I talk about here.
Risk of You (Poor trading)
The market is an unlimited environment. You have no one telling you what to do, and you are solely responsible for your own success or failure.
And you will go through poor patches of form, or market conditions that don’t suit your trading style.
It is during these times, if you don’t have effective processes for handling them, that you can quite easily make costly and harmful mistakes.
A good trader will have plans to:
- Notice when they are not performing
- Notice when they are not in the right mental state
- Take action to limit any damage
- Get back into form
For example, you might reduce your positon size when you are not preforming. You could also do a mental state check each day before you trade. A good rule is that you should stop trading for a while after a certain number of losses, and then be very active (but at a reduced size) until you regain some form.
Time to take out your trading plan
Now over to you.
Take out your trading plan and spend some time thinking creatively about how you can manage these risks when you trade.
It’s important that you then write down your plan, because in the heat of the moment if it’s not written down, you are liable to make mistakes. When you write it down, you make a commitment to yourself and your trading business. A commitment to follow the rules you’ve set for yourself, protect your core capital, and get it right even when times are bad.
These are essential skills for any trader.
About the Author
Sam Eder is a currency trader and author of the Definitive Guide to Developing a Winning Forex Trading System and the Advanced Forex Course for Smart Traders (get free access). He is a co-owner of Forex Signal Provider FX Renew (Get a FREE 30-day trial). If you like Sam’s writing you can subscribe to his newsletter.