Risk management is one of the most crucial determinants of a trader’s long term success in the market, because it helps us cut down losses and reduces the probability of losing our capital in the market . When choosing the lot size before executing a position, there are almost no limitations, but in order to satisfy the possibility of fulfilling his long term goals in the market, each trader must comply with some rules regarding risk management. Managing risk means having a specific plan regarding the risk associated with each transaction you take on the market.
The first important component to risk management is that lot sizes must always be proportional to a trader’s capital. In simple terms, for any trade you wish to execute, you should not risk more than 2% of your trading funds. This is due to the undeniable possibility of a losing streak, which happens even to the most skilled trader in the world. If you are risking more than 2% per trade, a losing streak can drain your account rather quickly. Another factor that supports this idea is that when you suffer a significant drawdown on your account, a higher percentage gain is required just to restore your trading capital to the initial value. Let’s take a simple example to demonstrate this phenomenon. If we have a sum of $10000 on our trading account, and we are risking 5% per trade ($500), a series of four consecutive losses will lower our balance down to $8000, which is a 20% reduction of our initial funds. In order to regain what we lost, we now need to gain 25%, instead of 20%. This is because we now have a lower capital, and our 5% risk equates to $400, instead of the $500 we referred to previously. Making a profit of $2000 from a balance of $8000 implies a 25% gain.
The second element of risk management is that traders should always risk the same percentage of their capital on each and every single transaction. If we have certain entry criteria, we wait for them to be confirmed and then we look to execute. Despite our subjective beliefs about a trade, if we are following our strict rules, the amount of winning and losing trades will be randomly distributed across a sample of setups. In simpler terms, we as traders do not know which of our trades will turn out to be losers. If we risk 0.5% on some trades, while 2% on others, the latter might turn out to be the losers. In this scenario a trader’s performance over a certain period of time might result in a loss, or breakeven, when he could have been profitable, just by being systematic with his risk management strategy. In conclusion, a trader must decide in advance the percentage of risk he is going to employ on every future transaction, and that percentage should range anywhere between 0 and 2%. Study the next lesson for a practical tutorial on how to calculate your risk.