Key parameters of risk management

28-04-2021

Financial trading has a tremendous advantage over other types of business: the risks are completely manageable.

Let’s take a look at the key parameters of risk management and how they can help novice traders to preserve and maximize their capital.

Contents:

1. Key parameters of risk management: What should traders focus on
2. Risk/reward ratio
3. Trading risks
4. Number of losing trades over a period

Key parameters of risk management: What should traders focus on

Trading is always risky even if you’ve got the best trading strategy. We are the traders, so we deal with the probability. Consequently, our forecasts may not work out well even with the right analysis. With that said, your losing trades aren’t equal to your unsuccessful trading results. A good rule of thumb is that the profit covers the losses.

To this end, you should use the key parameters of risk management:

  • Risk/reward ratio;
  • Risk per position in monetary and percentage terms;
  • Number of losing trades over a period (day, week, or month).Let’s go over each of these parameters.

Risk management: Key parameters

Risk/reward ratio

Risk management and money management are based on the following rule: cut your losses and let your profits run. The stop-loss order is the key risk management tool—be sure to always use it. Scalping strategies where you lock in your losses manually with fast trades can be a minor exception. This also includes long-term portfolio strategies where you trade without leverage.

Any trade makes sense when the potential profits exceed the risks. Therefore, we recommend that you aim for 1:3 on average in your profit/loss ratio, but the more it is, the better.

The risk/reward ratio depends on:

1. Trading strategy. Some offer 1:2–1: 3, while others can surprise you with 1:10. For example, a price action strategy can offer 1:2 once materialized and 1:3 according to its indicators. And if you enter the market with higher time frames, you can even get, e.g., 1:8 at some entry points. Note that this is just an example.

2. Expected value. If the profits prevail over the risks, you can level the losses caused by losing trades. Test your strategy and find out what win/loss ratio it offers with a large sample. Calculate the expected value and find out the minimum profit/loss ratio.

Trading risks

You must factor in any risks when making any calculations. Money management is all about measuring how much you can lose in the worst-case scenario.

You need to calculate what percentage of your deposit you’re willing to put at risk in one trade. You don’t just pluck this figure out of the air—it should be based on the expected value offered by your trading strategy. Usually, we don’t recommend exceeding 1% of your deposit if you stick to cautious risk management, and if this figure is even less, your strategy will be even safer.

How to put the risk percentage parameter into practice? Once you’ve found it, calculate the relevant position. The lot is based on:

  • Stop-loss size placed according to the trading strategy requirements and the existing market situation;
  • Deposit size;
  • Risk percentage per trade.

Risk management: Identifying lot per trade

QUICK FACT!

A better option is to enter the formula in Microsoft Excel to calculate the lot size. You can also use Trader’s Calculator.

Number of losing trades over a period

Even the best trading strategy can generate several losing trades in a row. This can be beyond your control. However, it’s not uncommon for a series of unprofitable positions to be a result of mistakes made by traders.

Let’s say the first two stop-loss orders wrecked it all. Because of a lack of proper focus, you opened another trade that brought losses. You really wished to bounce back and stepped on a slippery slope of trading on tilt, which eventually sent your trading deposit down the drain. FOREX risk management should have clearly measurable parameters, such as the profit/loss ratio, volume, and the number of losing trades per day (week or month) because they help you understand when to stop and take time for analysis and rest.

However, even when traders have clear risk management systems, they do fail. It’s not easy to stick to your own rules because of emotions and psychological make-up. This is why you need an outside assistant who’s impartial and cold-blooded.

With this in mind, Gerchik & Co came up with Risk Manager, a software solution that enables you to enter your own parameters, including the allowable number of losing trades for each period. When your emotions push you to break your own rules, Risk Manger won’t let you open any trades.

COMMENT