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Capital management. Risk management.

Every trader should know how to use technical and fundamental analysis. However, this knowledge is not enough to become a professional trader. To perform profitable deals, traders should master their capital management skills. In other words, they should control their risks and money.

The key idea of capital management is to increase profits whereas risk management is aimed at reducing losses. In this chapter, we will discuss each aspect in detail.

Your success in trading highly depends on risk control. You should start using loss reduction strategies, which will help you perform successful deals even in case of unexpected losses.

All deals involve some degree of risk. General principles of risk management will help you minimize possible losses. Below, you can see several methods of controlling losses. They can be applied by both beginning and experienced traders.

  1. Do not neglect to prepare for trading

    You should not underestimate preparation for trading. Before risking your money, make sure that you are opening the right deal. Besides, it is important to understand what financial risks you may face. Thus, before opening a deal, forecast potential losses in case the market moves against you by 5%, 10%, or 20%. It’s better to calculate the biggest losses. You will succeed in risk reduction if you perform only those deals that you have effectively analyzed.

  2. Develop and follow your own plan of trading.

    Every trader should have an individual method of trading. Traders’ behavior can be based on fundamental factors or technical indicators, or on both. As usual, traders try out and modify their methods as many times as necessary until they get positive and permanent results. Before risking your money, make sure that you have developed a reasonable approach that will bring you profit. The most important thing is to decide what sum you can lose. As soon as you reach the sum, close your position. Closely follow your method and avoid impulsive behavior.

    If you do not stick to your plan, then you do not have it.

    A carefully considered plan can help find out the main factors that influence your deals. Besides, the plan can be used to avoid mistakes in future deals. Moreover, it will give you confidence and prevent you from rash decisions. But do not follow your plan blindly. If you do not understand the market situation or you are getting too emotional, it is better to close positions. Do not rely on market rumors or recommendations. In general, make thorough preparation and consider possible variants of deal development before starting trading.

  3. Use diversification..

    You can minimize your risk diversifying your portfolio. There is no necessity to invest all money in one deal. Diversify your risks using only 5% or 10% of your funds to open a deal. To achieve the goal, you should be sure that the diversified portfolio includes the instruments the correlation of which you know well. (Correlation is a price movement of particular instruments at the same period of time).
    If you open a long position on EUR/USD and a short position on USD/CHF, you actually have only one position. The fact is that these instruments are highly correlated (their price movements are very much alike). Thus, you have only one position but with a double risk. In reality, it is the same if you open two positions on one of these instruments. You should always control relation between all your positions, keep portfolio balanced and adjust it. Stop orders reduce risks and losses that you can face trading on highly volatile markets.

  4. Do not invest all money you have.

    First of all, make certain that you have enough money to compensate for unexpected losses. If you have an impression that a particular deal is very attractive and has a chance of becoming profitable, it is better to stop and think everything over. The first impression can be wrong as market conditions are seldom favorable. In case the market changes its direction, for example, to a downtrend, it is recommended to have a particular sum of money to compensate for losses or deposit additional funds to meet the margin requirement. Additional money can help you avoid stress and additional risk.

  5. Use stop orders

    Stop orders reduce risks and losses when you trade in volatile markets. To achieve success, follow the rule: leave the market if your losses hit 5%-7%. Even professional traders set stop orders to limit risks. You should also close positions if your plan turned out to be false. Do not neglect stop orders at the beginning of your trading career because they can protect you when you really need it. If the market does not meet your expectations, leave it even if you still have all your money. There are traders who prefer time stop orders. In difficult or unclear situations, time stops remind you to leave the market.

  6. Follow the trend.

  7. If you follow the trend, you will hardly face losses. If you follow a particular trend, market direction is not that important. If you have opened a losing deal, it’s better to reduce the risk size gradually.

  8. Be ready for mistakes and learn to face losses.

  9. It is very important to admit mistakes and close deals even if you can lose money. Experienced traders also suffer losses from time to time. Nobody likes admitting failures thus it can be rather difficult to follow this rule. In fact, you should increase profit and reduce losses. If you open a deal against a particular trend, do not add to the losing position hoping to compensate for losses. If you do not understand the current market situation, close the deal. It is better not to open a new order as you need to calm down.

  10. Trade safely.

  11. “The most important rule is to play great defense, not great offense,” one of famous traders said. First of all, you should compare your possible losses with your possible gains. Secondly, get ready to the worst scenario. Remember that the market can change its direction at any moment. Besides, you should know the maximum leverage available for your account type. Adjust stop orders if necessary. You should also have a plan to leave the market. Thus, you are ready to meet problems.

  12. Avoid excessive trading.

  13. To limit risks, reduce a number of deals and keep small bets. You should fully understand the risk that you may take. Open only one deal to have time to think over scenarios. As a result, you will have almost no chances to perform impulsively. You can concentrate on only one deal. Besides, commission charged by a broker will be smaller.

  14. Control your emotions.

  15. Every trader has suffered losses and great stress. Unfortunately, it is impossible to avoid such situations when trading in the market. Anxiety, frustration, depression, and sometimes despair are so-called side effects of professional trading. You should control your emotions to avoid their influence on trading. Rely only on rational and well considered decisions. You can communicate with other traders and share your experience and problems.

  16. If you have any doubts, better close positions.

  17. If you have doubts concerning your success, it means that your plan needs adjustments.
    Leave the market in the following situations:

    • - Market behavior is irrational;
    • - You are confident about profitability of the deal;
    • - You do not know what to do.

    You can risk your money, only if you are sure of what you are doing.

There are four stages of risk management:

  1. Clearly understand what you are risking.
  2. Avoid unnecessary risks.
  3. Think over possible risks.
  4. Perform actively when trading against the current trend. Risks and losses depend on the speed of your actions.

Let’s look at the examples of risk and capital management.

Figures in the examples were used to show the ideal market situation. In real life, you can find a lot of variants. It is important to follow the main principles of risk allocation.

First of all, let’s decide what size of the first deposit is the most suitable. According to the general theory of Western financial markets, a ratio between the sum you can risk and the deposit is 1:10. It is perfect, if you can afford to follow the rule. However, in most cases, traders are not able to do so. Thus, the average ratio is 1:5 or 1:3. It is better to base your calculations on the sum you can painlessly lose.

For example, you are ready to risk 2,000 US dollars. In this case, you need to deposit from 6,000 to 10,000 US dollars. If you decide that 1,000 US dollars is the biggest sum you can lose, you should have from 3,000 to 5,000 US dollars on your trading account.

The most popular leverage on the forex market is 1:100. The standard lot size is 100,000 US dollars, euros, or pounds. Margin call varies from 70% from a security deposit (margin) on one open deal to force closing of all positions when margin drops to 3%-5%. If there are several open deals, security deposits are summed up.
Spreads are from 3 to 10 pips for major currencies and from 5 to 15 pips for crosses.
In the following examples the deposit is not less than 5,000 US dollars. In the first example, the deposit equals 5,000 US dollars and you are ready to risk 1,500 US dollars.

  1. Account size – 5,000 US dollars
  2. Risk capital – 1,500 US dollars

Note that it is possible to low risk capital.

Leverage and margin call

Leverage and margin call do not play an important role when you follow your rules and calculations. Let’s use the standard leverage of 1:100 and margin call of 30%. In case you have 5,000 US dollars on your account and an open position, you will have to deposit additional funds when the floating loss hits 4,700 US dollars. Margin call will be executed when there are only 300 US dollars left. Thus, we have the following figures:

  1. Account size– 5,000 US dollars
  2. Risk capital – 1,500 US dollars
  3. Leverage – 1:100
  4. Margin call – 30%

Pip value of a standard lot

Let’s calculate the value of one pip for various currencies. A pip value changes together with a currency exchange rate. However, a significant difference will appear when a currency exchange rate changes at least by 300-400 pips. One pip equals $10 on the 100,000 contract for the euro and pound. The pip value for both currencies is the same as EUR/USD and GBP/USD are direct quoted currency pairs. Besides, contracts usually have the price of 100,000 pounds and 100,000 euros. A pip value for the Swiss franc and Japanese yen amounts to 10 units of a base currency (i.e. the franc or the yen). Then, the base currency is changed into the US dollars or it is divided by the current exchange rate.

Thus, if you trade USD/CHF with the lot size of 100,000 units, the pip value will be around $6. In case of the USD/JPY pair, a pip will be around $8.5. You can use the same method to calculate the pip value for crosses. Thus, you will have 10 units of the base currency that you need to change into US dollars.

Average and maximum losses for one position

It is necessary to estimate the average or the biggest sum of possible losses at least for three entries. However, from the practical point of view, it is better to forecast losses for 4-5 or even 10 entries. At this stage, you should take into account where you put the stop loss.

Besides, it is recommended to determine the highest possible loss for one position on such strong currencies as the euro and pound. You can also estimate the average losses for one position on currencies with lower exchange rates such as the Swiss franc and Japanese yen.
Thus, we can lose $375 for one ordinary position and $500 for a position on stronger currencies. To be more precise, we can lose $300-350 two times and $500 one time. In other words, it is around 30-35 pips on the pound, 40 pips on the Japanese yen, and 55 pips on the Swiss franc. The biggest losses will be the following: 50 pips on the euro and British pound, 60 pips on the yen, and 80 pips on the Swiss franc. Thus, we have finished the third stage of calculations:

  1. Account size - $5,000
  2. Risk capital - $1,500
  3. Leverage – 1:100
  4. Margin call – 30%
  5. Average loss amount on a position - $300-$350
  6. Maximum loss amount on a position - $500

Profit.

According to the theory, profit from one position is not less than 300% of possible losses. In other words, profit from one deal is three times higher than a possible loss. Thus, we can get around 90-100 pips on the pound and euro, 120 pips on the Japanese yen, and 150-160 pips on the USD/CHF position. However, with such a small balance we cannot always use the risk-to-reward-ratio of 1:2. Nevertheless, it is not recommended to try a smaller ratio. Thus, we have the following figures:

  1. Account size - $5,000
  2. Risk capital - $1,500
  3. Leverage – 1:100
  4. Margin call – 30%
  5. Average loss amount on a position - $300-$350
  6. Maximum loss amount on a position - $500
  7. Minimum profit on a position – from $600 to $700

Besides, you should also take into account spreads, brokerage fees, and rollover charges that can be taken in a triple size for Friday, Saturday, and Sunday. However, do not change the main principles used in the calculations above. You can only make some adjustments according to your trading strategy.
For example, if you want to get profit of 150 pips from the Swiss franc position, you need to hold this deal for two or even three days. The total amount of losses can be divided between the following three days. It means that during these three days you will suffer the biggest losses. And then, you can divide the total amount of losses by the average number of entries for every day.

If you want to open and close around 5 positions a day, your losses for the given period will total $300-$350. Losses from one position will be $65-$70. Do not forget about your profit that should equal not less than $120-$140. But, there are some exceptions: you cannot follow the scheme if you prefer the intraday trading.
In case of intraday, medium-term (one or two days), or long-term trading, distribute losses and use 1/3 of risk capital for every type of deal. The intraday trading can be performed during one week with 3-5 entries a day. The medium-term trading can also take one week with only three entries a day. Besides, you can develop your own rules to control yourself. For example, if during one week, your balance reduces three out of five working days, it is better to make a pause and find a mistake. Do not trade until you reach margin call or the biggest possible losses. You can develop your own strategies but still follow the main principles of risk and capital management. The key aim is not to exceed the level of possible losses. Profit making is the secondary goal. Only this approach can help you save money. If you do not limit losses, after several profitable deals you will lose all your money.

Nevertheless, most traders make an attempt to guess market direction. And in case of a failure they prefer to wait until the market starts moving in the needed direction. Using risk and capital management, you can easier cope with unexpected problems.
However, it is not enough to know the theoretical part; you should also practice trading using your plan. If a particular stop loss is reached, it is better to close a losing position and adjust your trading strategy. Otherwise, you will have higher risks or even lose all you money. Thus, it is recommended to accept losses when they are rather small as they can turn into great ones. The greatest mistake you can make is to ignore a stop signal. The situation can become worse if the market changes its trend contributing to your success. The point is that at this moment you are likely to make new mistakes. Leave the market and analyze the situation again. If after that you still have confidence that the market will reverse, open a new deal with new stop orders.

Questions for revision
  1. What is capital management?
  2. What are the main principles of capital management?
  3. What is a risk size?
  4. According to your capital management rules, a risk size of one deal does not exceed 5% of all your funds. The account size is $5,000. Where should you put stop loss, if a pip value equals $10. Give the answer in pips.
  5. According to the capital management rules, to open a deal, you can use not more than 20% of all your money. The account size is $5,000. The margin is fixed, 1,000 per lot. The leverage is 1:100. What is the maximum deal size?

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