The Business of Trading - Managing and Controlling Risk

All business involves risk. As for the business of trading, there is no method with 100% certainty that could allow us to buy cheap and sell dear all the time. The way that the financial market work we could not tell for sure whether the market is going to go up, down or sideway. The best we can do is to do our due diligence to study the market fundamental and technical and take a calculated risk when the potential reward is higher than the risk.

We therefore need to manage and control our risk so that we do not put our trading business at undue risk when our analysis turn out to be wrong.

How do we manage and control our trading risk?

The best advice I have read on the subject is the 2% and 6% money management rules given by Dr Alexander Elder in his best-selling book "Come Into My Trading Room".

How would we apply the 2% and 6% money management rules to trading?

Let's look at my EUR/USD long trade on 17 Mar 2011 as an example. See my earlier posting for detail in http://swingtrader188.blogspot.com/2011/03/eurusd-long-trade-17-mar-2011.html

The entry was made at 1.39291 and the initial stop-loss order was placed at 1.38600 giving an initial risk of -69.1 pips. The 2% money management rule means we should not risk losing more than 2% of our trading account size per trade.

Let's say you have a USD10,000 in your account. How many units of EUR/USD should you buy to limit your risk to 2% of your trading account size?

The maximum loss per trade calculation is shown below.

Maximum loss per trade = USD10,000 x 2% = USD200

The pip value of EUR/USD is USD10 per lot (100,000 units) per pip. The risk assumed for this trade is -69.1 pips. The maximum lots allowed = USD200/(69.1 pips x USD10/pip) = 0.28943 lot = 28,943 units.

This means that with your USD10,000 account you should not buy more than 28,943 units for this trade so that you would not lost more than USD200 per trade.

Can you buy 28,943 units? Yes, if you use OANDA FXTrade. Otherwise you have to round it down to 2.8 mini-lot (28,000 units) or 28.9 micro-lot (28,900 units) depending on what is allowed by your brokers.

The 6% money management rule means two things:

1. You should not risk losing more than 6% of your trading account size for all your opened trades.

2. Your maximum allowed loss per month is 6% of your trading account size.

With a USD10,000 account, the maximum allowed risk for all opened trades and the maximum allowed loss per month is USD10,000 x 6% = USD600.

Disclaimer:

Trading and investment involves risk, including possible loss of principal and other losses. I shall not be responsible for any losses or loss profit resulting from trading or investment decision based on my posting and any information presented in this blog.