We are here attacking the first lesson of what we call “the work of the trader”, ie everything that does not strictly concern the analysis … If you ask yourself what trading can ask for as competence to apart from the analysis, you are in the right place.
What is risk management?
Risk management, also known as money management, refers to a set of rules and principles that will allow you to maximize the efficiency of your operations, and avoid taking too many risks, or at least risks that are not mastered.
For some people, these principles will seem obvious. However, keep in mind that when you really invest your money, you do not think so lucidly. We are won by stress, fear, and hope , which can sometimes “pollute” our ability to make rational and effective decisions.
This is where risk management comes in.
In fact, by setting strict rules in advance , we manage to overcome the difficulties caused by emotions such as fear or hope, two of your greatest enemies when it comes to trading on Forex.
Risk management is a somewhat tidy concept, so we are going to teach you here the most indispensable notions, the ones you will need directly at the beginning of your trading career.
Managing your capital
Main rule: do not use too much of your capital
Here, the notion of available margin is paramount. As a reminder, the margin available is the amount on which you can intervene, taking into account the leverage effect. For example, if you made a deposit of $ 1,000 on your account and you use a leverage of 100, your available margin is $ 100,000.
However, you should never use too much of your available margin, be wary of the leverage allowed.
For example, in the previous case, if you take a big position relative to your capital, for example on 50000 units, each variation of 1 pip will represent 5 dollars.
So, with 100 pips in the opposite direction of your position, you are already losing $ 500, which is half of your capital .
And once you reach 200 lost pips, your capital has gone up, and you’re going through what’s called a “margin call,” which means that the broker automatically cuts your position and your account is at zero …
There are no precise rules to know what proportion of its available margin should be used, but in the present case (deposit of $ 1000, leverage of 100), it seems advisable to limit oneself to positions of 10,000 units, where the value of the pip is 1 dollar over EUR / USD.
By prudently using your capital, you will be able to cope in the event of a transient change to your position. You will be able to hold the position until the trend becomes favorable again (if you have good reason to think that your position is always wise and you have simply made a timing error).
To conclude, do not be too greedy . Admittedly, the bigger the position, the faster and faster the gains, but we must not forget that it also works with the losses!
Pay patiently for gains on reasonable positions, increase your capital, then increase the size of your positions, this is the best way to be sure to last in trading.
Risk management of positions with stops and limits
We have previously learned to manage our capital, now learn how to manage our positions. In this field, the notions of Stops and Limits are paramount. Let’s start with the definitions:
Stop: We call stop the limit of maximum latent loss that is fixed. This is the threshold from which we consider that we were wrong in our position, and that our analysis is false.
That is, we cut our positions as soon as the stop is reached. For example, you buy EUR / USD at 1.3060: If your stop is 10 pips, you will set it at 1.3050, and cut your position at this price.
Limit: A limit is the opposite of a stop. This is the goal of gain that we set. This is the threshold from which we consider that it is wiser to cash out your winnings than to hold the position. Specifically, with a limit of 10 pips, if you buy EUR / USD at 1.3060, you will sell at 1.3070.
Stops and limits can be defined “orally” or automatically , which we recommend.
You can automatically place stop and limit orders on your platforms, so that positions are automatically closed if they have reached the stop or limit.
The usefulness of stops and limits
The interest is obvious in the case of stops: Avoid being caught in the game of “it’s good, it’ll go back” , because by doing so, you will drag long losing positions, which will undermine your margin and therefore your ability investment.
Our opinion is that if the courses go in the wrong direction, it is better to accept it and move on . Things move very quickly on the Forex, and it is better to accept to have been wrong than to wait for the courses back up and to let go of opportunities.
For limits, it will be to avoid being “too greedy” waiting too long before taking his winnings on a winning position. Many traders doing this have been surprised by the speed at which prices fall after a spike …
An old stock market adage says that trees never go up to heaven, and it is better to take profits early than to wait too long and face a brutal turnaround that will wipe out your winnings.
We strongly advise you to place your auto-stop stop and limit orders right after your position statement, and not to touch it anymore . Once the position is taken, we are not so lucid, and we may be tempted to disregard the rules we have set, which is usually a bad idea.
In addition, with automatic stops and limits, you will not have to monitor the position closely, which is more comfortable.
How to choose stops and limits?
Firstly, we must know that the more we invest in the short term, the more our stops and limits will have to be tight. Then everything depends on your strategy, everything depends on the risks you want to take …
However, it will be necessary to ensure that your limits are always wider than your stops.
Your winning positions must earn you more than you lose your losing positions.
But this principle alone is not enough to properly position its stops and its limits. Indeed, the risk management intervenes in the choice of the levels on which one will set its stops and its limits, but the analysis also intervenes.
To conclude, risk management aims to help you overcome psychological errors, mistakes that can lead you to make your emotions. But for that, it is also essential to know each other well, to know the psychological biases that the trader is often subjected to: This is the subject of the following lesson.