RISK & MONEY MANAGEMENT


Learn the difference between being risk averse and risk seeking, which affect emotions and eventually your trading performance. Practically apply techniques to avoid costly mind traps.

More about managing your mental state and having the right mode of beliefs are covered in greater length in the Trading Psychology section.

LEARN MORE ABOUT TRADING PSYCHOLOGY

We most often hear about how emotional traders become when their losses keep multiplying or when they struggle to breakeven. Subsequently, desperate and disheartened traders believe that they need to get back at the market to recoup losses–this is called ‘revenge trading’. So, how do traders revenge trade? Well, it's almost too easy from being in a least resourceful state driven by false beliefs to actually falling into the trap of overtrading. Simply by making the mistake of not managing lot sizes, traders lose control over their fast diminishing equity, almost to the point of no return.

Before going further, it's essential to first understand what money and risk management entails as they do slightly differ from one another. However, managing your money will enable you to manage your risks as one compliments the other. Their differences are explained below.


WHAT'S THE DIFFERENCE BETWEEN MONEY & RISK MANAGEMENT?

MONEY MANAGEMENT

To properly manage your money you would need a system or formula that will enable you to decide your lot sizes. In other words, it's about how many lots to trade for every single trade you are thinking of executing. Having a system in place will allow you to take emotions out of trading and reduce risky intentions in using instincts or gut feelings to make financial decisions.

Risk management answers the question of:

How big a lot size you are supposed to open per time of trading?

RISK MANAGEMENT

Managing one's risks is directly related to an individual's risk tolerance. In order to manage your risks better, you would need to be aware of the impact your trades will have towards your remaining equity in your trading account before either getting a margin call or being stopped out. Therefore, managing risk of any trade could be measured based on the percentage of your account equity you are willing to risk, if the trade goes against you.

Risk management answers the question of:

How disciplined are you in not breaking the 'percentage of equity to be risked' rule?

Respective of the subject of money and risk management, traders are habitually confused about where they should start from or what exactly they need to know and apply into their trading.

With that, we came up with crucial pointers as tips whilst ranking them in level of importance from #1 to #5.

Question: How big a lot size you are supposed to open per time of trading?
Answer: You need to first decide on two crucial areas as follows:
1. The amount you are willing to risk/lose in $ (e.g. 3% of your capital).
2. The amount you are willing to risk in pips.
Example:

Let’s assume you are starting with an equity balance of $10,000. Based on the above you are willing to risk 3% of it. This will be $300. Based on your strategy, by determining support and resistance or through indicators, let's say you decided on a stop level of 100 pips, which is the amount you personally wish to risk.

What you can do is include the answers to the above into the simple formula below:

IDEAL LOT SIZE TO TRADE = RISK IN DOLLAR AMOUNT / RISKS IN PIPS
= $300 / 100 PIPS
= $3 PER PIP (MAXIMUM FOR THAT SPECIFIC TRADE) / RISKS IN PIPS

This would mean you are going to be typing in the option of 0.30 once you click on 'New Order' and under the 'Volume' section, which is equal to 30,000 units. See example below specifically for the EUR/USD pair:

Volume: 0.30

However, please be aware that value per pip may vary in accordance to the base currency of your account and the chosen instrument as shown in the table below:

INSTRUMENT BASE CURRENCY TRADE SIZE
(Units for currencies, Oz for gold)
PIP VALUE
EUR/USD EUR 30,000 2.82 EUR
USD/JPY USD 30,000 2.66 USD
AUD/USD AUD 30,000 3.91 AUD
GBP/JPY GBP 30,000 2.12 GBP
CHF/SGD CHF 30,000 2.12 CHF
XAU/USD(Gold) USD 1 Lot (100 Oz) 1.00 USD

*Note: The % amount you want to risk from your equity is a personal decision that you need to be accountable for.

Why do I need to know the margin requirement?

Margin requirement is necessary for you to determine what your margin call and stop out levels are.

Definition

When a trader opens an account with a broker for example, an initial deposit is required to open a position in the market. The required cash deposit will act as a capital to cover any credit risk. Depending on the terms and conditions of the agreement, the trader could be able to leverage up to a certain limit.

Margin requirements could also be considered as the leverage offered by a broker. A 2% margin requirement is equivalent to a 50:1 leverage while a 1% margin requirement could be referred as a 100:1 leverage.
Margin = 1/Leverage

To understand the margin using the simple formula mentioned above, see the example below:

Example:

Let’s say that by default the leverage offered at the broker is 1:50 then the margin

would be = 1/50
= 0.02 × 100
= 2%

Margin Requirement: Units Traded × Current Price × Margin
To understand the margin using the simple formula mentioned above, see the example below:

Example:

You want to buy 100,000 euros (EUR) with a current price of 1.070 USD, and your broker requires a 2% margin.

Required Margin = 100,000 × 1.070 × 0.02
= $2,140

Based on the example above, you will need a minimum balance of $2,140 to be able to sustain the trade you wish to execute. You will then be able to convert based on current exchange rates into euro.

*Note: Please refer to the Pip Value Table depending on the base currency or chosen instrument.

Margin required depends on which currency your trading account is denominated in. For example:

  • Margin Call = 80%
  • Stop Out = 50%

Account Equity = Required Margin × 80% (to get a Margin Call)
Account Equity = Required Margin × 50% (to be Stopped Out)

Definition

Traders are usually alerted when their equity is equal to 80% of the required margin. They will get an alert from their broker; it will simply be a red highlight on the MT4 trading platform.

A margin call is telling you that your equity is insufficient to keep the active trades opened or to continue trading. To keep active positions opened means that a trader may have to either close some of the trades or deposit more funds to their trading account to meet the minimum margin requirements.

Margin Call

At a broker for example, the margin call = 80%. First, you would need to know the margin requirement to find out your account equity, which would alert you to the margin call as per the formula below:

Account Equity = Required Margin X 80% (to get Margin Call)
Example:

Following the example as shown in TIP #2, the margin requirement needed for trading the EUR/USD was $2,192 so you would need to insert the details into the formula above as follows:

Account Equity = $2,192 × 80%
= $1,753.6

*Note: This means that once your equity has been reduced to the amount of $1,753 your broker's trading platform will be highlighted, alerting you to a margin call.

Definition

Traders are usually stopped out when their equity is equal to 50% of the required margin, in which their account will trigger a stop out.

Stop Out Level

A stop out level is neither an alert nor a warning anymore because once you ignore the margin call and fail to fund your account, the system will perform an automated closure of all your trades as mentioned above.

Example:

Following the example as shown in TIP #2, the margin requirement needed for trading the EUR/USD was $2,192 so you would need to insert the details into the formula below as follows:

Account Equity = Required Margin X 50% (gets Stopped Out)
= $2,192 X 50%
= $1,096

*Note: This means that once your original equity has been reduced to the amount of $1,096 you will most likely be stopped out.

**Please refer to the Pip Value Table depending on the base currency or chosen instrument.
Definition

A drawdown is simply a drop in your account size or equity and usually presented as a percentage of the account.

drawdown

A drawdown can be stated in one of two ways:

1. To consider the losses in absolute terms, such as money or pips.
2. To consider it in terms of percentage.

The percentages will help you with the analysis in the capacity of the specific trading strategy, while the absolute values ​​of money or pips will help primarily in the construction of your trading portfolio. Whichever approach that's chosen, in any event, would coincide in supporting the decisions on risk and money management.

Why seeing that a loss in percentage is better

Percentages, as illustrated in the table below, help us to observe the drawdown from another interesting perspective. If you lose 50% of your equity, to return to the break-even level, it will not be a new performance of just that 50% that you have lost, but rather it’s 100%. The reason being, if you had lost 50% of your equity, you have halved your gains; therefore, you have a lower amount of capital or have halved your capital. To make sure that half will come back to being a whole, you need to double it; in other words, to create a performance of a 100%. You must therefore always be careful because the higher the drawdown, the more the struggle will be to recover the profits.

LOSS OF CAPITAL (DRAWDOWN) REQUIRED RETURN TO REPAIR DRAWDOWN
10% 11.1%
20% 25%
30% 42.9%
40% 66.7%
50% 100%
60% 150%
70% 233%
80% 400%
90% 900%
100% Oooops!