THE GOLDEN RULES OF RISK MANAGEMENT

What is risk?

The risk of trading is the amount of money you are willing to lose. It’s not actually what you lose, it’s what you could lose. You can define risk in many ways. There is market risk, credit risk, operational risk, and systematic risk. Most of the risk you will experience as a trader is market risk.

Most traders assume that the exchange they are trading on will remain operational. If the exchange you are using defaults, you would experience credit risk as there would be no authority to make sure you will get paid on the trades that you currently have open. Operational risk describes a situation where a company does not execute. If you own shares in that company, you could experience operational risk. Systematic risk is the breakdown of the entire system. During September 11, 2011, the world experienced systematic risk.

What is risk management?

Risk management in forex trading and other markets is a process used to minimize risk. You design a framework which will mitigate the amount you could lose. You can do this at all levels, but it should start at the portfolio level. When you allocate capital to your trading venture, you need to determine in advance how much are you willing to risk to achieve your financial goals.  Remember, you get paid to take risks—the greater the risk, the greater the expected reward.

There are risk-free strategies where you can earn a certain return without taking any risk. For example, if you live in the United States you can purchase treasury bills. Three-month bills pay 2.5% annually, and that is backed by the full faith of the United States government. So, unless the US government defaults, you will earn the value of a treasury bill. If you live outside the US and purchase a treasury bill, you will then expose yourself to currency risk.

Once you have determined how much you are willing to lose, you can back into how much you expect to generate. Using a reward to risk ratio of 4:1 is reasonable. This means for every $1 you risk, you should expect to make $4. This does not mean that you need to make $4 on for every $1 you trade, but it’s a good goal.

Risk at the strategy level

Each strategy that you employ should fit into a framework where your ultimate goal is to hit your portfolio goals. You might combine scalping strategies with trend following strategies and even pair trading strategies.

Scalping strategies might win more than it loses, but the amount you make is similar to the amount you gain. If this is the case, then you need to win four times more than you lose, to approximate a $4 to $1 reward to risk. That would mean you need to win 80% of the time and only lose 20% of the time.

You might combine this strategy with a trend following strategy which is a strategy where you might lose more than you win, but the amount that you win is four times as much as when you lose. By combining multiple strategies, you might provide yourself with a better chance of meeting your financial goals.

Risk management at the trade level

Prior to placing a trade, you should have a good idea of how much you plan to lose and should set a mental stop loss. You can then determine where you should take profit. With scalping trades, your reward to risk strategy could be 1:1.  With a trend following strategy, you might set your profits at four times your stop loss level. For example, if you are trying to determine your forex risk with a currency pair, you might take profit when the exchange increases four big figures and stop loss when it falls one big figure. You also might consider a trailing stop loss, that moves up as the market moves higher.

Conclusion

Risk management helps you determine the framework you will use to make money. A key concept is to make sure you cut your losses and let your profits run. You need to break down your risk management at a portfolio level, a strategy level, and the trade level. Be realistic in terms of the amount you are attempting to gain relative to the risk that you assume. Additionally, while market risk is the most likely risk you will encounter, you will also be exposed to credit risks, operational risks, and systematic risks. For traders to be successful, it’s essential that they have realistic currency risk management strategies in place.

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