Risk Management is an essential survival skill for every trader.
Without good risk management, we quickly drift into dangerous territory that could cause us to lose a lot of money unnecessarily.
This article will discuss how to create a sustainable and even risk exposure, regardless of what type of trade one enters.
Stop Loss and Trade Size – A Crucial Relationship
It is essential to understand the relationship between your trade size and stop loss in order to know the risk you are taking on a trade. Changing just one of these factors (i.e. lot size or stop loss) can have profound effects on the overall risk you are taking during any setup. In order to achieve a consistency in your equity curve and maintain an equal degree of risk exposure throughout your trading, you need to work out a unique relationship between your stop loss and trade size for each individual setup.
It is not a good idea to have a fixed lot size with which you enter every trade, and neither would it be advisable to have a fixed pip value that use as your stop loss for every trade. This is because no two setups are identical, even if you trade the same strategy or system. Sticking to a fixed lot size or stop loss will either overexpose you or the trade may not get enough space to work itself out.
Say, for example, you always trade with the same lot size of 1.00.
In one situation, you decide set your stop loss 25 pips away, which means you are risking roughly $250. But in another setup, you set the stop loss 50 pips away; you are now risking $500 (double the amount), even though you are trading with the same lot size. This unevenness in exposure can very quickly come back to bite you.
4 Steps to Good Risk Management
You will create much more sustainable trading results if you go through the following 4 steps in the right order (please note that I have provided a shorter summary of these 4 points at the end of the article):
- Decide on a fixed amount of money you are willing to risk per trade. This should ideally be based on your trade account balance. A reasonable amount of risk could be anything between 0.5% to 3% of your account balance. This should be the only factor that is fixed and pre-determined for every single trade you take.
- Decide where a good stop loss level is located. A good stop loss setting is decided by a technical invalidation level, not by a fixed number of pips. A technical invalidation level is a price level where it becomes highly likely that your original analysis is incorrect, and therefore it becomes no longer worthwhile staying in the trade beyond this point, like for example at the break of an important support/resistance level. Finding suitable invalidation levels is a skill in its own right and will be discussed in a future article. But for the sake of this article, it will suffice to say that you need to decide on a clear technical stop level BEFORE deciding on your lot size.
- Once you have determined a good stop loss level, you are coming to an important decision point. If your technical analysis reveals that you would need to set your stop loss further away from your entry point than your projected target, the setup is probably not worth entering. That’s because you are risking more than you stand to gain when your stop loss is bigger than your target. There is also no point to simply set a bigger target if there is no technical reason that validates the idea that price could actually reach this bigger target. That’s how you can filter out bad setups from good setups. Ideally, you only want to enter trades that have a potential to gain more than you stand to lose, which is called the good Reward-to-Risk ratio.
The chart above shows a recent example of a GBPUSD setup that had a good reward-to-risk ratio. Price had formed a clear triangle pattern over several weeks and began to break out of it. The potential to the upside was very big, with space for price to rise at the very least to the green target line ( I won’t go into the technical details here). The invalidation level on the other hand was relatively close to the entry point, i.e. at the bottom of the triangle pattern (red line).
Conversely, the chart below shows the same GBPUSD chart but with a different setup later on. The break had occurred and uptrend was established. One could have considered entering a buy position at the pullback (blue line). But in this situation the technical invalidation level was much further away from the entry point than the target, thereby creating a bad reward-to-risk ratio. Even though price broke through the target eventually and continued higher, this was not a certainty at the time the trade would have been entered.
In any case, if your technical analysis shows that a good reward-to-risk ratio exists, then you are ready to proceed to the final step in your risk management process… your trade size.
- Once you know how much of your account balance you want to risk per trade, and have determined a clear stop loss level, you can work out the correct lot size for your trade. Your lot size will govern how much money you risk per pip of price movement. 1.00 lot will roughly mean about $10 loss/profit per pip. In order to work out the lot size that will give you equal risk exposure for every trade you enter, calculate the following (The figures next to the formula are an example):
(Amount of money you want to risk) $500
(Number of pips of stop loss) 35
(Amount of Money you are able to risk per pip) $14.30
DIVIDED BY 10… EQUALS
(Correct Lot size for your Trade) 1.43
Here are the 4 points in summary again:
- Decide on a fixed amount of risk you want to take per trade (0.5% – 3% of your account balance)
- Determine good stop loss setting through technical invalidation level
- Determine if the setup still provides a worthwhile reward-to-risk ratio based on the invalidation level you have analysed.
- If yes, calculate your trade size via the formula I provided above
If you follow these 4 steps, you will have taken a major step towards creating a sound risk management protocol that should see you safely through any trading situation.
Make sure to tune into follow-up articles where we will dive more deeply into stop loss settings.
All the best along your trading journey…