Risk Management and Trading Psychology
The majority of this section outlines various Forex related principles that you can build on. We strongly suggest that before trading a strategy you quantify it and test it to see if there is a valid edge. However keep in mind that past performance is not an indication of future results.
Even the best strategies in the world would easily fall apart without proper risk management or when you let your negative emotions take over.
To provide a simple example imagine a strategy that is correct 9 out of 10 times. That’s very good 90% accuracy. However what if on the one time that it is wrong it wipes out your entire account. That is poor risk management. So even the best indicators, strategies and systems in the world, are all nothing without proper risk management. And mediocre systems can be potentially very successful if a proper risk management strategy is applied.
We deliberately combined the risk management and the psychology sections together. Because it is typically poor risk management that leads to negative emotions, that eventually break down the trader. The main reason that a trader will attach to a particular trade and not get out until it’s too late is because a trade is too big for his account. The two worst emotions for a trader are fear and greed. Both of these emotions are attached to money; fear of losing money and greed of getting money. They kick in when you are trading two big for your account size. If each trade does not represent a significant portion of your account size you it is much easier to follow your predetermined rules and evaluate situations with a clear head. Also it is important that your Forex trading account is not too big compared to your bank account. In this case your emotions are defiantly likely to kick in. It is almost guaranteed that you will lose if you are trading money that you cannot afford to lose. So don’t underestimate the power of emotions. Trade Small!
If we were to do a full section on risk management it could potentially take up thousands of pages. And some of the principles could literally make or break a trading strategy. The members section includes more in depth information about risk management and how it can be applied to various trading strategies.
In this particular section we will cover two basic rules: The 2 percent rule and the aggregate portfolio stop loss.
The two percent rule states that you cannot risk more than 2% of your account on any one single trade. This number may be sometimes higher depending on a particular trading system. But the bottom line here is that your maximum loss on any one single position must be predetermined and we strongly suggest that it does not exceed 5% of your account. The calculation for this is very simple and should be used in your trading.
First figure out what the most you can loose on any trade, based on your stop loss or trading system. Than simply divide your predetermined maximum loss based on the 2% rule by this number and you get your maximum lot size to trade on the position.
Let’s set up an example. If you have a $10,000 account and you are adhering to the 2% rules so the most you can lose on 1 trade is $200. Now if your stop loss is 10 pips away, this means that you can trade up to two standard lots on any one position since 10 pips multiplied by 2 standard lots is equal to $200 which is your maximum single trade allowable loss based on the 2% rule.
Now another rule that you should adhere to is the aggregate account stop loss. Before you make your first trade predetermine how much of your account you are willing to risk on your trading strategy. This is very important when combined with trading psychology. Before you even think about making your first trade you should know how much you can afford to lose in your account before you decide that you should reevaluate things. This way you will be able to keep your negative emotions out of your trading and simply follow your Forex trading strategy.