Risk Management is a critical part of the trading plan. It enables us to minimize losses and maximize profits. This is where we must be disciplined and follow the rules. Big losses are the main destroyer of your account, and we can keep the risk on a trade to what is expected by setting a hard stop loss.
Problems Traders Face:
- Being afraid of your stop loss being hit and closing trades early is not correct. Getting stopped out at your predetermined stop loss is correct.
- If you hate being wrong and move or remove your stop loss is not correct. Getting stopped out is correct and part of trading.
- Taking too much risk that you can’t afford to lose is not correct. Following your money management plan is correct as it should take into account how much capital you have.
Risk: Represented as R
Each trade will represent 1 Risk or 1R. We find that taking profit on position 1 at 1R works well. This means to set your profit target the same distance away from your entry as your risk and is the minimum we want to take profits. Remember that the smaller the profit target, the easier it will be to reach. Many trades will hit 1R and then reverse back to breakeven (BE).
Think of the price like flowing water, it wants to take the path of least resistance. You don’t want it to have to flow uphill or through walls to get to your targets!
You should set up the trade in such a way that you can reach your first profit target without having to cross a level if possible. Sometimes this is unavoidable and you may want to pay attention to what the price does at that level, and adjust stops or target if the market confirms a reversal. Or simply set up the trades and let them stand until either the initial stop loss or profit target is hit. This will be the easiest and the best approach to trade management.
Further testing could be done with targets on trades in different market conditions. For example, having larger targets in trades with the trend or in a breakout area.
Open Positions:
Only have a maximum of 3 trades open at risk at one time. If a trade reaches the first profit target it is no longer at risk. Don’t take multiple trades in different markets which include the same currency. For example EURUSD and EURJPY. If the setups are in the opposite direction then it is fine, but if they are in the same direction it is basically doubling your risk as if one moves against you then most likely both will. Market correlation is important though it can often change. Be aware of which markets are moving in similar directions.
Drawdown: The amount your capital drops before reaching a new high watermark in your Equity Curve.
The following rules apply when you are in a larger than average drawdown. We find that by following them, we can pull out of a drawdown quicker.
- Do not take countertrend trades.
- Set your profit target to 1R on both positions.
Position sizing will be determined by your capital and the money management strategy you choose to follow. It is the final piece of the plan and one that will determine how quickly or slowly your capital grows or shrinks.
Trader’s Mindset: Acceptance of Risk
You must learn to accept risk if you want to be a successful trader. Easy, I accept it! Well, it’s not that easy and is the root cause of fear and pain in trading. It is one thing to say it, and a completely different thing to live it. The reason trading is so difficult for most is that you have to do what is uncomfortable. Namely, have confidence in yourself and your edge while facing uncertainty in the market day in and day out. The only way to develop those skills is through hard work. Are you ready to put in the work and commitment to change?