It's ironic though, that for new traders, Risk Management is the least important aspect of trading. Everybody wants to learn about best entries and such first. They think that's where the money is. It's human nature; we usually tend to look for the easy way regardless of whether it's the correct way or not.
I'm a big fan of old Martial Art movies. Not the ones where they effortlessly jump on top of 3 storey buildings, but those where young people go to a Martial Arts master to teach them his craft. Once the master accepts them as his student/trainee, he sets them mundane tasks such as cleaning the floor, moving certain items from one place to another etc. day in day out. Eventually most students get really frustrated with extreme disappointment. After all, they wanted to be the best kung-fu fighters, not handymen or cleaners. Most drop out. The ones that stay the course, however, start to realize that Martial Arts is a life style practice, not a fighting one. They also come to understanding of mastering the art takes time and hard work.
Especially after hearing and reading all those stories how so-and-so made lots of money by trading currencies. Wild west gold rush begins... Looking into it a bit further then download some trading platforms and start trading paper money. Watching price moving.. seeing all those dollar pips rolling fast on most likely M1 and M5 charts. Sure we are excited by now and thinking the prospect of making a lot of money without any hard work. Already we start to imagine/dream about rich life style. At this stage our reasoning logic should be telling us "hang on, this looks too good to be true", but who cares about sensible reasoning here. It's all blocked by our greed. That devil in us starting to take control.
http://readthemarket.com/images/arti.../smiley-01.pngThen we discover all those wonderful indicators and oscillators. Magic...
"It looks so easy... Even using simple MA crosses can make a lot of money. I don't have to do anything. Just watch the crosses and enter". One thing, the deadly important aspect we overlook here is that these indicators are showing the past, not the present.
All indicators are lagging. I have not seen any working non-lagging or non-reprinting indicator to date. I suppose once time travel is invented it'll be possible to make non-lagging indicator.
http://readthemarket.com/images/arti.../smiley-02.pngWhen we discover the lagging aspect of these indicators we most likely will have some noticeable disappointment but at this stage we still are excited.
These wonderful indicators are much like a cheap hooker.
"That's fine" we say, "I'll go for classy expensive hookers". We imagine we can find a fine tuned, perfect indicator or system that produces winners consistently.. Then we start searching for that magical indicator or system, download and test many of them, try to fine tune them, buy some systems, enrol in some courses and so on..
http://readthemarket.com/images/arti.../smiley-03.pngSome of us end up wasting considerable amounts of money on these useless systems and courses. By the end of this stage most traders get wasted or give up on trading. On the other hand some decide to go back to the drawing board and re-start from scratch with the understanding that learning to trade may take a lot more time than they had anticipated at the start.
I'd like to make it clear that I am not against using certain indicators for information purposes such indicators that shows price, highs, lows and so on. The key is not to base your trading decisions on any indicator other than your main indicator: the chart itself and price upon it. Try not to pollute your charts with useless indicators until trading becomes your second nature. At this level it doesn't matter what indicators or how many of them are displayed on the chart; you'll ignore them and look for the prices and levels automatically, instinctively.
http://readthemarket.com/images/arti.../smiley-04.pngIf you are new to trading, please do yourself a favour before buying any magic system or enrolling in paid courses, by asking these simple questions:
• If these bullet proof black box systems are as good as their vendors claim to be, why are they selling it instead of using it for themselves? If I had such a magic system, I wouldn't sell it, at least not to the public. They'd be worth millions rather than this few hundreds bucks. I myself don't know the existence of any magic system that works so far.
• If those mentors and teachers were so great, why don't they teach it for free? I don't buy the argument that they get greedy and want to make more money. Think about all the time and effort they put into those courses. Surely it could be utilized in trading, a much more rewarding career. However, I do buy the argument that some people are good at teaching but not so good at trading, so they are making their living from the greater talent. Nothing wrong with it. I only recommend to new traders choose carefully and choose the best ones if you don't want to end up wasting your time and money.
Out of the last group [Traders who went back to the drawing board rather than give up] only the ones who get to grips with a sound and disciplined risk management will survive.
In my view, the first thing to teach to a new trader is risk management. At least the great importance of it.
A new trader may not take risk/money management seriously as he or she may be thinking "what the heck, I have only a 5K account and I know what's there. I know what is a loss and I know what's a win.. So what's to manage there.. I need to improve my entries first.. Money management will take care of itself as long as I have great entries". However, in reality, the first thing to be mastered is sound risk/money management.
Risk Comes From Not Knowing What You Are Doing – Warren Buffett
Warren Buffett put it short and sweet as to the source of a risk. Risk is heavily associated with uncertainty where we do not fully know the outcome of a certain situation. Consider someone working on a complex project. He has a much harder task identifying and managing possible risks than a trader has. As traders we have a much simpler task when it comes to identifying the risk/s and managing them. There are only few variables we need to take into account. However, we have a harder task sticking to pre-defined discipline, due to the personal aspects of trading. Greed and Fear kick in and start messing with our psychology.
Trading psychology is the end product of how we manage our fear and greed within the framework of risk management.
http://readthemarket.com/images/arti...gm/fear-01.jpgThe fear part is easier to understand and deal with. Fear originates from the unknown, the risk; we can manage to control it by avoiding stupidity and applying certain rules based on practical knowledge. On the other hand, greed is a totally different kind of beast. It's not so easy to control.
Ideal traders would be those that are bored, don't care about material things in this world and don't get on emotional roller coasters easily. Forget about Hollywood stuff. They are just movies.
I will try to illustrate below that even a mediocre trader with sound risk/money management can be a consistently profitable trader over a period of a time.
Lets say, as a new trader you just learned the basics of supply and demand zones/levels. Plus engulfing candle pattern. [See here for detailed explanation of engulfing candle pattern]. You can identify where to draw your supply and demand zones. If you find it difficult to spot the zones at first instances, then use SupDem indicator which draws it for you automatically. It's not perfect but it does the job. I still use SupDem indicator. Why? Can't I spot them? Sure I can but there are certain situation when farther left zones are easily not visible unless you keep scrolling your chart. If the SupDem indicator doing it for me why should I do it manually?
As a new trader. I'd suggest you start trading on higher timeframe [HTFs] charts such as H4 or H1. Why is that? Is it easier to trade on HTFs charts? From a technical point of view there is no difference. You'll have the same price movement, and the same principles apply both higher and lower TFs. The main difference is relative speed. There are other aspects, but that would be a subject of another article and not needed here. Even though, for better entry opportunities, looking at lower TFs is a good idea but let's leave that until we learn and understand overall price action and structure within zones better. This way you'll avoid immature panic and fear to a certain degree. That's all.
I was thinking to use simple illustrations but for the sake of realism and clarity lets use actual charts. As most new traders will likely choose EUR/USD to trade, I'll also stick to it in this exercise. Once you learn to read charts properly after 1000s of hours of screen time, you'll come to understand the saying "Any pair, any time frame".
http://readthemarket.com/images/arti...gm/risk-02.jpgTHE RISK PROFILE
First we need to define our risk profile in line with our account size. Don't overlook THE RISK PROFILE. It's the heart of the matter. Extremely important.
If it doesn't make much sense at the beginning, take your time until you grasp the essence of it. Do it right... Do it wisely.
Never, Ever put your real money in any trading before you fully understand the risk management, and can define your very own RISK PROFILE.
Understanding and defining it is just the beginning. You MUST apply it to your trading with discipline as if your life depends on it.
What do we include in Risk Profile?
1. What levels of Risk:Reward [R:R] ratio will we be working with?
2. What's the maximum percentage of our account we are willing to risk on any one or more trade/s?
3. What's the maximum position size we can use?
4. In terms of pips value what's the maximum stop we'll be using?
5. Are we going to use break-even and trailing?
6. What time frame will we be trading?
1. Minimum R:R [Risk:Reward] ratio we'll work with is 1 to 2. This means that for every pip we risk we want to gain 2 pips.
2. We don't want to live fast and die young and pretty. We will not risk more than 2% of our account in any one or more trade/s. You may have come cross similar phrases before in books and articles. One thing is some of them don't make it very clear: Does 2% is applly to an individual trade? If so, can I open other trades simultaneously as long as I don't risk more that 2% of my account on any one of them? Of course not. Remember, we are talking about our total available account value, not the count of open trades at any one time. Depending on your account size, position size and stop value you may only be able to open one trade if the trade risk value is close or equal to 2% of your total available account value - available margin.
However, you can still open more than one trade even though when you open the first trade it's risk value may have been 2% of your available account value. How? Simply by locking your first trade when it's moving in your favor as long as you take into account spread and slippage. What this means is you have decent distance between your entry and current price so that you are able to move your stop at least break-even to +10/15 pips. Trade is locked and the risk is reduced almost to zero. Depending on your available margin you may be able to enter another trade. An important point to remember is that markets can gap in either direction over the weekends. I'd strongly advise never leave such trades open over the weekend. As a beginner, I'd say do not leave even a single trade open over the weekend. Additionally, keep in mind that an unexpected big incident can cause gaps too, such as natural disasters etc. Unfortunately, we cannot do much about these.
3. Position size we can use will depend on the account size. Even $5k will provide you with enough margin to trade a standard [std] lot if your broker gives 1:100 leverage. Using this kind of account setup and trading it with std lot will most likely kill your account in no time. In my opinion a suitable relationship between account size and position size as follows
- 100k+ for trading in std lots - 1 std lot [1.00] per pip value = $10
- 20k+ for trading in mini lots - 1 mini lot [0.10] per pip value = $1
- 5k+ for trading in micro lots - 1 micro lot [0.01] per pip value = $0.10
Ps/. Please note the above lots values refers to certain instruments such as EUR/USD etc. Some other instruments have different lot values. While 1 standard lot value of EUR/USD pair is equal to US$10, 1 standard lot value of Silver is equal to US$50.
4. We will use a maximum of 40 pips stops. However, we will try to spot entry opportunities with less than 40 pips stops too but we will not take entries with more than 40 pips stop value. Therefore we'll be taking on trades that offers 80+ pips where entry required 40 pips stop [minimum 1:2 RR we already defined]. Well, how do we know if the entry offers minimum of twice the our stop value? Are we magicians or what? We of course don't know the outcome in advance, but supply and demand zones give us some idea. If we are buying in a demand zone with 40 pips stop and we see 45 pips above supply zone the most likely there is not enough room to get our minimum 80 pips.
Please understand that, not all offered possible rewards are realized at all times. Price may turn at any time against us before reaching our pre-defined target. This is where using break-even stops becomes handy. We shouldn't let a winning trade turning into a loser.
5. We will use break-even and Trailing. When price moves in our direction. Around 50% of our target we will move our stop to break-even. Please note, break-even means here; we will move our stop to entry price + spread. If the spread for the pair we are trading is 2 pips and our entry was at say 1.4225 then we'd be moving stop to 1.4227. If price is moving nicely in our direction, instead of closing the trade after it reaches our initial target of 2:1 we'll consider trailing it by moving our stop to initial target when price advanced further in our favor.
6. Let say we choose to trade the hourly chart as we are new and bit nervous. It's also important to decide on timeframe as our stops and position sizing will vary according to the time frame we decide to trade on. With higher time frames, we will need bigger stops and smaller positions depending on our available account value - available margin.
So, we have worked out our Risk Profile as follows:
- We will use minimum of 1:2 Risk Reward ratio
- We will not risk more than 2% of our total available account [available margin]
- As we have only 26k account we will only trade using mini lots as our maximum position size per trade
- We will work with maximum of 40 pips stops
- We will be using break-even and trailing as defined above.
- We will trade on hourly charts only.
As long as we can stick to the above risk profile defined, we can enter 10 trades, have 6 looser and only 4 winners but still end up with profit overall. No, this is not one of those too good to be true systems. It's a simple reality and can be proven with numbers.
http://readthemarket.com/images/arti...gm/risk-03.jpgFor instance, say we used maximum of 40 pips stop for all 10 trades and used the minimum 1:2 reward to simplify the explanation here.
We had 6 loosing trades which translates into 6x40=240 pips loss
We had 4 winning trades which translates into 4x80=320 pips gain
So after 10 trades we have gained 80 pips overall
It's a simple fact but many new traders overlook such probabilities. It can do wonders for your trading psychology, especially if you are suffering in the hands of fear. However, for the above to work you must strictly follow the rules. The rules that you have defined yourself in your own risk profile. If you move your pre-defined stop against yourself, or exit trades before reaching the initial target it will fail miserably.
Please keep in mind, the above may vary in terms of trade count in reality. For example you may have 6 loosing, 2 break-even and 2 winning trades. In this case after 10 trades your account would be showing 80 pips loss. The point is, in certain circumstances it may take more than 10 trades to hit the plus as long as you do not panic and avoid doing silly things. We may also avoid such outcomes by taking trades when price is only in strong zones and ignoring weaker mid zones.