A new contributor to the Currensee Blog, Wenjie Tang is the lead trader at Trade Leader Alpha Harvest.
I often hear forex traders, some of them with years of trading experience, talk about what percent of their balance they use to trade. They are thinking about risk management concepts too simply:
How much money do you use to trade? “I use 10% of balance”
On a single trade? “I never put more than 5% on a single trade.”
Well, do you think that position is large? “I think that position is small because it’s less than 5% of balance!”
I believe the majority forex traders (mostly retail traders) don’t really understand the idea of leverage and position size. Let me list some of common questions from retail traders:
- What leverage do you use to trade?
- Is this leverage the same as margin rate that your broker gives?
- How shall we control position size?
- Is 5% of balance position is small or big?
To correct the assumptions behind those questions, let's begin with the idea of the "risk" of a trade.
Simple definition: how much money you can to lose or you can afford to lose. Assume that you have 10,000USD in your margin account. If you decide you can afford to lose 500USD on a bad trade, then 5% is the risk for a trade. If overall, you only want to allow 10% loss for several trades, than you can enter more trades, but they should not be allowed to lose more than 1,000USD all together.
Furthermore, when you get 1% margin rate from your broker, how much money do you actually use to trade for a 5% risk trade? Here comes the tricky part. You have to understand the idea of stop loss. If you trade EUR/USD and have 100 pips for SL in mind, then 5% risk on a trade means you can trade 0.5 lot. (1 lot = 100,000).
Here is the calculation:
- 5% risk on a 10,000 USD account = 500 USD
- 1 pip EUR/USD / lot = 10 USD
- 100 pip stop loss / lot needs =1,000 USD
- To stick to your 500 USD risk limit, you can trade only 0.5 lot with your 100 pip stop.
Wait a minute? What if SL is 200 pips away? And what if SL is just 20 pips? Which way is riskier? As long as you stick to the formula, it’s equally risky, because risk is still 5% of balance, which is 500USD. In case of 200 pips, you can just open 0.25 lot. With 20 pips SL, you can open 2.5 lots.
What are the leverages for above three cases? What if broker gives 200 leverage? I'll leave that math to my readers, but my point is that it doesn’t matter, you should only focus on how much money you can lose.
After all, risk is always the only thing we can control in trading. Once you see an opportunity to trade, calculate the SL and then trading lot size.
In complicated models, pros like to use probability models to evaluate the overall risk when there are a lot of trades. The idea is that if we enter 100 trades with each risking 0.1%, theoretically, the overall risk should be less than 10% because of the correlation or lack of correlation between the 100 trades. Retail traders probably should not attempt this.
So, what then are the correct questions to ask? Answering these questions will allow you to use the formulas above to get a better handle on risk:
- Risk in terms of % of balance per trade or on all positions
- Pip value and stop loss
- Trade lot size
What now? Once your risk is controlled, if you stick to your plan and the market goes your way, you can let your profits run!