How to Build a Trading Risk Management Strategy
In this step by step guide, we’re going to discuss how to build a trading risk management strategy to create a risk-adjusted performance. This risk management trading PDF can create an unprecedented opportunity for growing your trading account in an optimal way.
Risk management is widely recognized among professional traders to be the most important aspect of your trading plan. Our team at Trading Strategy Guides has created this risk management trading PDF that explains the key components of a good money management strategy. Also read bankers way of trading in forex market.
Risk management is the absolute most important thing that you can learn.
We’re going to teach you how to stay in the game. Staying in the game and making money on a consistent basis it’s all we care about. We’re not in this to make a one hit home run trade because anyone in the Forex market who has been long enough knows that’s not possible.
All of our market strategies have a trading risk reward ratio of at least 1:2.
There are many different ways to manage your risk and to manage your own money but in the end, it’s all about your risk tolerance and preferences. However, you need to have some sort of risk management system to make money in the FX trading.
Moving forward, we’re going to introduce you into the world of how hedge fund manager really looks at trading the markets.
What is Risk Management? - Risk management trading PDF
Risk management is the process used to mitigate or protect your personal trading account from the danger of losing all your account balance. The risk is defined as the likeliness a loss will occur. If you manage the risk you have an excellent opportunity of making money in the Forex market.
Basically, risk management it’s just a method to control the risk exposure when trading.
Risk management it’s like the foundation of a house. When you build a house you first start with the foundation layers and only then you start building the walls and the roof and everything else. On that note, risk management is the foundation of a successful trading plan.
We can basically break risk management foundation into 3 layers:
- Risk Planning
- Trading Risk Reward ratio
- Position Sizing
Moving forward, we’re going to explore how one can use these risk parameters to generate superior risk reward ratios for your trades.
Risk Planning - Trading Risk Reward Ratio
Planning your risk will help you maintain consistency with the risk we take trading the markets. Becoming a consistent trader is one of the biggest hurdles that you need to conquer and it can only be done right from day one if you plan your risk exposure.
So, when it comes down to planning your risk we need to be able to answer one simple question: How much are you willing to risk per trade?
Well, ultimately, the answer to this question is a personal preference and it comes down to your risk tolerance. However, professional money managers recommend not risking more than 2% on any particular trading idea.
The main advantage of the 2% risk rule is that you’ll be able to take more trades at any particular time. Conversely, the more risk per trade you take intuitively you’ll be prone to make fewer trades.
The risk per trade is something that you’ll probably begin to refine over time, but don’t try to ramp it up too fast until you’ve got some good trading experience behind you.
How to determine the risk dollar amount is simple:
Risk Dollar Amount = Account size * %Risk
For example, if your account balance is $5,000 and your risk tolerance is 2% your dollar risk amount is $100 per trade.
Risk Dollar Amount = $5,000 * 2% = $100
By calculating the risk dollar amount we can ascertain how much we’re going to lose if the trade goes against us. In our particular case the maximum loss would be $100.
Risk planning will help you better control the mental part of trading because you already know in advance how much you’re going to make if the trade goes in your favor or how much you’re going to lose if the trade goes against you.
Trading Risk Reward Ratio
The trading risk reward ratio simply determines the potential loss versus the potential profit on any given trade.
How to measure the risk reward ratio?
The risk is simply defined as the price distance between your entry and your stop loss.
The reward is simply defined as the price distance between your entry and your take profit.
In essence, in order to calculate the risk reward ratio you only need three components:
- Entry Price
- Stop Loss
- Take Profit
In order to determine the risk to reward ratio, you simply need to divide the potential “Total Risk” to the potential “Total Reward:”
Risk Reward Ratio = Total Risk / Total Reward
In order to figure out your total risk, you need to apply this simple formula:
Total Risk = Pip Value X (Entry Price – Stop Loss Price)
In order to figure out your total reward, you need to apply this simple formula:
Total Reward = Pip Value X (Entry Price – Take Profit Price)
As an example, if you're planning to enter a long position on EUR/USD at 1.2200 with a stop loss at 1.2150 and a profit target at 1.2300 you’re basically having a risk reward ratio of 1:2.
Risk Reward Ratio = $1 x (1.2200 - 1.2150) / $1 x (1.2200 - 1.2300) = 50 / 100 = 1 / 2
We want to have a strategy with a higher trading risk reward ratio as this will ensure our profitability in the long term.
For example, if your risk to reward ratio is 1:2, it means your win rate has to be above 33% to make money in the long-term (see Figure below).
Position sizing answers another important question, namely: How big a particular trade should be?
Is it arbitrary?
Or should you always be buying 5 lots or 1 lot?
There are several ways you can determine how big that position should be. It’s entirely under your control to determine how big your position should be.
In order to be able to calculate our position sizing we need to know three things:
- Account size.
- How much of that account you want to risk – percentage-wise. We have examined this under the Risk planning section.
- Stop Loss.
The basic formula for calculating your position size is:
Position size= (Account size * % Risk per Trade) / Stop Loss
Let’s imagine the following scenario where we have a fictional account size of $10,000. We have a risk tolerance of 2% per trade and based on our analysis, we figure out that we need a 50 pips stop loss.
Applying the above formula, it results that our position size should be 4 mini lots.
That was easy!
Moving forward we’re going to discuss two of the most popular risk management strategies:
- Fixed Fractional Money Management Strategy
- Fixed Ratio Money Management Strategy
Fixed Fractional Money Management Strategy
Using fixed fractional money management strategy means only risking a percentage of your trading account on each trade typically 2%.
Each trade you take, you can’t risk more than 2%.
The advantage of fixed fractional strategy is that as your account grows, you’re increasing your position size with the growth of your account. So, you’re getting the same kind of results as you would be if your account is $10k or $50k and so on.
However the disadvantage is that if your account has a drawdown all of a sudden your risk of ruin increases. By using a fixed ratio strategy you can tackle this disadvantage.
Fixed Ratio Money Management Strategy
The fixed ratio strategy uses a specific position size that increases and decreases with your account balance.
Let’s consider the following scenario:
You’re having an account balance of $5, 000 and your fixed position size is $10 per pip. The next step a trader will follow when applying a fixed ratio money management strategy is to decide when to increase your position size. Of course, this all comes down to your preferences and risk tolerance.
For example, you can double your position size after you have made another $5000 then your position size will increase to $20 per pip. This concept is known as DELTA.
In fixed ratio money management, the delta represents the amount of profits you need to make until you increase your position size. In other words, you’re using the delta as a benchmark to increase your position size.
You can break down your Delta in different increments to better suit your risk profile. For example, you can use a position size of $1 per pip for every $1000 in your account. So obviously if you’ve got $5,000 account your position size will be $5 per pip. Once your account dollar grows to $6,000 after you’ve made an additional $1000 profit your position size will now grow to $6 per pip.
You’re basically using that ratio of increase depending on your initial capital.
Risk management is the absolute most important thing that you can learn. In our next section, we’ll present all the factors why is having good risk management so important.
Why is Having Good Risk Management so Important?
While Forex trading can be fun, it does come with an inherent risk that you need to understand.
Having a trading risk management strategy is probably the most important aspect of your trading process because it will guarantee the long-term survival throughout the ups and downs of your trading career.
Your number one priority as a trader should be capital protection because profits do care of themselves.
Applying risk control into your Forex strategy will enable you to be in control of your emotions because you already determined how much you’re going to lose before jumping into a trade.
Risk management is going to permit you to trade in a smart way and give you the flexibility to choose how much you want to risk per trade in a way that will allow you to maximize your profits and minimize your losses.
If you apply the risk management principles taught through this guide you’ll have a much greater chance to survive in this Forex business. However, not following any money management rules has the potential to break your trading career.
The good news is that this risk management trading PDF is easy to grasp as there is nothing complicated about money management.
Conclusion - Trading Risk Management Strategy
Not having a trading risk management strategy we’re basically risking the entire trading capital and risk of getting a margin call. Smart trading also means that you need to have a trading risk reward ratio of minimum 1:2 in order to survive in the long term.
Money management has proven many times to turn a losing strategy into a winning one. So to overcome the limitations of your trading strategy you should focus on your trading risk management strategy.
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