Forex Investment and Currency Trading

When it comes to trading, risk management is frequently an afterthought – that is, until you take a loss that you weren’t expecting. Suddenly, the wisdom of the ages is upon you, and you vow never to let it happen again.

By the way, who in her right mind would ever put on a trade expecting to take a loss, anyway? Sounds crazy, right? But all the experienced traders calculate the risk they’re facing in every trade before they ever enter it. It’s part of their decision-making DNA, and it goes a long way toward determining which trade opportunities they pursue and which ones they skip.

We strongly recommend that traders approach the forex market with risk management as the first thought. It’s how you’ll be able to get some trades wrong and still survive to get other trades right.

Analyzing the trade setup to determine position size

The starting point for any successful trade is developing a well-conceived trading plan. And the most important element of a trading plan is the size of the position that will be traded. Position size will determine how much money is ultimately at risk, as well as the overall viability of the trade.

But position size is only one half of the equation that determines how much money is at risk. The second half of the equation is the pip distance between the entry price and the stop-loss level. Wait a minute, you may be thinking. Why didn’t we mention the upside potential or the pip distance between the entry price and the take profit? Why aren’t we looking at how much money we can make on the trade?

Save the rose-colored glasses for buying lottery tickets. When you’re plunking down only a dollar or two, it’s okay to focus only on the upside and dream about winning millions. But when you’re trading in any financial market, you have to remember that the market is not there to give you money.

We know you’re not drawn to currency trading for the chance to lose money. You’re interested in making money, and you’re prepared to take some risks to do that. The questions is how much risk you are prepared to accept. Because you’re dealing with finite resources in your trading – namely, the amount of risk capital you’ve devoted to your trading – you have a definite limiting factor to your trading. If you eat through your trading capital, you’re done. So the starting point of a risk-aware plan has to focus on the downside risks.

That brings us to the trade setup. A trade setup is a trade opportunity that you’ve identified through either fundamental or technical analysis, or a combination of both.

In every trade setup, you need to identify the price point where the setup is invalidated – where the trade is wrong. For example, if you’re looking to sell a currency pair based on trend-line resistance, price gains beyond the trend line would invalidate your rationale for wanting to be short. So the price level of the trend line is the line in the sand for the overall strategy.

Now comes the entry point for the trade. Let’s say that current market prices are 50 pips below the trend-line resistance you’ve identified. That means the market could move higher by 50 pips and your trade setup would still be valid, but you’d be out of the money by 50 pips. You now have a clear delineation of how much risk your trade setup would require you to assume. If you get in now, you’re risking at least 50 pips.

Alternatively, you could reduce that risk by waiting and using an order to try selling at better levels – say, 25 pips higher. If the market cooperates and your limit-entry order is filled, you’re now risking only 25 pips before your trade setup is negated.

So how large a position should you commit to the trade? From a risk standpoint, it all depends where you’re able to enter the trade relative to your stop-out level.

Doing the math to put the risk in cash terms

After you’ve identified where your stop-loss point is – where the trade setup is negated – and where you’re able to enter, you’re able to calculate the amount of risk posed by the trade. Let’s say you’re inclined to enter the position at current market levels, and your stop is 50 pips away. For example, if you’re trading a standard-size account (100,000 lot size), and the trade is in NZD/USD (where profit and loss accrues in USD), each lot would translate into risking $500 (100,000 x 0.0050 NZD pips = $500).

If your margin balance is $10,000, you’re risking 5 percent of your trading capital in this trade, which is frequently cited in trading literature as the maximum risk in any one trade.

There are no hard and fast rules as to how much you should risk in any single trade, but we recommend limiting your risk to no more than 10 percent of your account balance.

If you’re able to enter the position at a better level (say, using the order to sell 25 pips higher), you’re now risking only 25 pips on the trade. You could double the position size and still be risking the same amount of trading capital. Or you could stick with the single lot and cut your risk in half.