The Ultimate Guide to Risk Management

| Risk Management |

This thread will serve as an all encompassing guide to learning how to approach risk management from scratch. Hopefully by sharing this knowledge with you I can dispel some common myths, clarify hotly debated topics, and bring profitability to your trading by breaking the numbers down in an easy to digest format. There will be quite a lot of information contained within this thread so read carefully, remember that it's your money on the line!

Also if there's anything I should add or clarify more on then be sure to let me know!

 

1. When making a comment about risk management, make sure to understand that there a many different ways to approach risk management but only a few are proper for a beginner and the type of strategy being used (as explained below)
2. This thread will only accept proper risk management strategies geared towards beginner traders. Strategies that aren't complex and convoluted and easy for a beginner trader to use as a foundation for how they should approach risk.
3. If you're a beginner trader and you start to become confused after reading many different comments and suggestions made by other users on ForexFactory, remember to just come back to this original thread and cross-analysis, use this as a your book of Golden Rules.

At some point I'll also release one of my custom Lot Sizing programs to help you instantly calculate the proper lot size for each trade you make (there are some already online but none really did what I wanted). I'm eventually going to make the program into an EA so one could quickly hit Buy or Sell and the position will be perfectly sized according to defined risk management protocols, that way all of this information can be wrapped up in a single button click.


Steady trading!

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Risk/Reward
The amount of risk that you take in order to make an expected amount on a trade is known as the Risk/Reward and is expressed as a ratio. The ideal ratio is of hot debate. There are warring parities of traders (mostly retail traders) who say 1:1 is the best ratio,1:3 is better, or 1:2 is ideal. There are others who say that the ratio is completely meaningless and should be discarded altogether. Others say that a R/R is only for those who like to "set and forget" their trades of which consists only of the dumb, rookie trader crowd whom have minimal trading experience. There's a ton of differing opinions on the Risk/Reward ratio and the subsequent debates that follow can make a beginning trader confused and lead them in the wrong direction, which is dangerous for their long-term success. Let me dive in...

Most people have day jobs unlike the 'professional' traders who sit at their computer all day scouring 32 currency pairs on 12 computer screens. Not everyone will have the same time allocation as other traders so as a reuslt everyone will use different trading strategies that bend to their daily routines. The static R/R is best used for traders who don’t have the time to watch their computer screen all day long analyzing price action every 15min.

A static R/R is also good for basic EA management schemes so as to backtest a certain strategy and produce qualifying metrics.

R/R ratio is also applied differently to different types of strategies. For some strategies a static R/R serves as a guideline for their risk management. For these types of strategies there should be a minimum R/R maintained for every trade taken with the potential to increase the ratio to let winners run and ride a trend. Other strategies find the R/R irrelevant to their trade setup process (even though behind the scenes they still maintain a positive expectancy ratio unwittingly).

Here are the most popular strategies you will use in your daily trading and how R/R should be different for each one even when strategies might have the same or varying win rate:

Trending Based Systems

Exit Method: Reversals, Consolidation Zone, when trend has officially ended using custom indicator/cue (most trend strategies use this)
Exit Type: Trailing Stops (dynamic), Breakeven (dynamic), Pre-determined SL/TP (static)
Calculating Metric:

Dynamic: Average Win : Average Lose

Static: R/R same for all trades

R/R should be higher (1:3 minimum) to maximize profits.

Must maintain a minimum R/R with each trade

Ideal Trader: Active involvement needed with possibility to set SL/TP to time breakouts and ride trends. 1-2 hours needed

Range Based Systems

Exit Method: Based on defined market structure
Exit Type: Trailing Stops (dynamic), Breakeven (dynamic), Pre-determined SL/TP (static)
Calculating Metric:

Dynamic: Average Win: Average Loss

Static: R/R same for all trades

R/R should be lower (1:2 being the minimum) to boost win rate in a time where choppy markets produce more losers.

Must maintain a minimum R/R with each trade AND must not get too greedy and aim for more, strict R/R

Ideal Trader: Those who prefer ‘set it and forget it’ type of strategies where R/R ratio is static and stable with market conditions. 1 hour needed

Market Maker Systems

Exit Method: Based on defined market structure; price action evaluation
Exit Type: Trailing Stops (dynamic); Breakeven (dynamic); NO static TP/SL exists
Calculating Metric:

Dynamic: Average Win: Average Loss

Static: N/A

R/R cannot be calculated until after trading history is generated

Depending on what kind of market maker phase you’re trading, R/R should still be maintained at 1:3 for the trending phase and 1:2 for the consolidation/expansion phase to beat the statistical win rate odds

No minimum R/R needed

Ideal Trader: Active involvement in their trading spending 3-4 hours on the computer. Not a laid-back strategy.

Dynamic Price Acton Systems (discretionary price action trader)

Exit Method: Based on price action (no clear mechanical entry/exit)
Exit Type: Trailing Stops (dynamic); Breakeven (dynamic); Staggered TP/SL (dynamic) NO static TP/SL exists
Calculating Metric:

Dynamic: Average Win: Average Loss

Static: N/A

R/R cannot be calculated until after trading history is generated; it is arbitrary in this strategy

No minimum R/R needed

Ideal Trader: Active involvement in their trading spending 3-4 hours on the computer. Not a laid-back strategy. This strategy's profitability is entirely dependent upon the skill level of that trader and their understanding of price action.


There isn't a ‘holy grail’ 1:2 or 1:3 ratio that must be used at all times for all strategies. Risk/Reward isn't a one size fits all number, rather it's dependent upon what underlying strategy including the type of entries, exits, and market dynamic it plays upon. You might have a 30% winning strategy with a 1:10 risk ratio and it be profitable. Or 80% winning strategy with a 2:1 risk ratio and it fail miserably.

Beware, some strategies are dependent (they are designed from the start) to revolve around the R/R. This is a slippery slope and is like trading on a House of Cards. Meaning the only way a strategy is able to win 80% of the time is BY adjusting the R/R to risk more than what it earns. These are dangerous strategies and it saturates the EA world. Adjusting the R/R to start risk more than what it earns will increase win rate and may be profitable for 6 months. But in 9 months, or a year it will fail because it's breaking an important rule to never risk more than what you earn when trading on margin.

One shouldn't start with setting an arbitrary Risk/Reward ratio and then whip the strategy into submission to fit this triangle of a number into a square strategy. Rather one should start with a strategy and then deduce the R/R from that strategy. If the R/R is not sustainable based upon the win percentage, then the underlying strategy is bad and there's no amount of tweaking the risk settings you can do to 'fix' it because then you'll inadvertently change the strategy itself when you start tinkering with the SL and TP levels.

In the end a winning strategy MUST be over 1:1 for it to be profitable regardless of win rate. 1:2 for beginners (in ranging markets), and 1:3 for beginnings (in trending markets). And it's also dependent on the type of strategy and exits that you use. If you're using a a dynamic exit then you'll never know how many pips you'll get so instead of focusing on R/R, you focus on price action and getting it right. Once you manage your trade effectively (and have the time to do so), R/R becomes irrelevant to the discretionary trader. To the automated, minimal time trader, R/R must be maintained at the minimums always in order to come out on top.


Key Points
1. Determine what kind of trader you are by figuring out how many hours a day you can dedicate to trading. Do you need a hands-on strategy or a more laid back approach? If you need hands on, then follow a strategy that capitalizes off of Trends. If you need more laid back then use a Range Based system. Or increase/decrease the timeframe that you trade. If you’re super hands on and ready to spend many hours a day then use Market Maker or Dynamic Price Actions systems where you need to react fast to moves in the market.

2. Now find a strategy that uses ONLY the market dynamic of your choice and stick to it. If you want to test a new strategy or run another strategy at the same time, do it in a separate trading account using separate money management schemes.

3. If your strategy uses dynamic exits, then R/R will not help, only the forward test results will determine the “true” Risk/Reward ratio, and at that point it is after the fact. Backtesting and forward tests are crucial. Remember that most strategies and systems that use dynamic exits fail and it's mainly due to the fact that you need to forward test in order to figure out it's true R/R and Win Rate. Forward tests of course take a lot of time, getting about 1,000 trades just for a accurate measurement (and even making 1 trade a day could take you 4 years to get up to 1,000 trades).

4. If your strategy uses static exits, then a positive R/R is critical for long-term profitability and you must use a strict 1:2 for ranging markets (not increasing or decreasing the ratio) and 1:3 for trending (not decreasing the ratio but you CAN increase the reward). When you decide on what R/R to use, make sure to never change it by risking more on "100% certain trades" or risking less on trades in a "choppy market." Doing so will invalidate your profitability metrics and is a recipe for negative growth. Stick to the same R/R once you decide on it.

5. This also applies to your % of balance at risk. Once you decide on a % to risk on each trade, DO NOT change it. Don't increase your risk on the next trade because you're 99% certain it will blast off into space and don't reduce your risk because "I don't know where the market is going so I'm place small risk". Both actions will harm your strategy by not taking full advantage of your wins and letting greed wipe out your account. If you're risking 1% on each trade (ideal for beginners and experts), stick to it at all times! If you don't have confidence in a trade setup, don't decrease the lot size, instead you skip it. There will be more opportunities.

5. Last thing to remember is that you cannot change a dynamic exit strategy into a static one without ultimately changing the strategy itself. Fitting a triangle into a square does not work without breaking something. And if you now create a new strategy, you therefore must forward test it which takes a large amount of time just to see if it's profitable in the long-run.


More trading concepts to come!

Statistical Probabilities

Another topic I'd like to discuss that NOBODY seems to bring up is the matter of statistical probability and how it affects your trading strategy and thus your trading account.

Let's say you have a coin that has a 50% chance of landing on either heads or tails. It has a theoretical chance of landing on either heads or tails 50% of the time but in reality that is not what we'll see. You flip the coin 1,000 times and guess what, it landed on heads 50.03% of the time and tails on 49.7% of the time, slightly different than an exact 50/50 break but it's okay because it's within an acceptable range.

But now let's say you take the same coin with the same odds, and instead of tossing it 1,000 times let's toss it 250 times. Now after 250 flips we have different outcomes. The coin landed on heads 52% of the time and on tails 48% of the time.

Now...let's flip the coin 50 times. Now the coin has landed on heads 32% of the time and on tails 68%.

Wow! What a huge discrepancy going from an even 50/50 break to 68% being against us. This is the realm of statistical probabilities and it has HUGE implications on your trading.

Using a simple coin toss simulation we can change our winning percentage just by adjusting the number of iterations of coin tosses we perform. The more coin tosses the less 'randomness'. The less coin tosses the more 'randomness'. This is independent of whether our underlying chances were 50% heads and 50% tails or if it was 80% heads to 20% tails. There is greater randomness with a smaller sample size, always.


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Let's say we find a strategy online from John Doe who's selling his winning system on YouTube. He claims it wins 60% of the time and makes 1 trade a week which is "more than enough to make money in the markets." We need a large enough sample size to even verify his 60% claims first of all.

We need at LEAST 500 trades to accurately and confidently say this system produces 60% win rate over 90% of the time without major percentage deviations. A lot of systems are traded on the hourly and 4 hour timeframes and they use dynamic exits (thus they are manually traded and there's no EA to backtest the system). So even making 1 trade a day on a 4 Hour chart, it'll take 2 years just to forward test and verify that claim. So right off the bat I'm already suspicion of this strategy, but nevertheless we'll assume we have the 500 trade sample size we're looking for.

We know we'll win 60% of our trades, we just don't know in what order we'll receive our winning trades. And due to the random nature of statistical probability, it will be random. At times we'll have series of 4 losses in a row or 20 consecutive wins and 20 consecutive losses at other times. The higher the sample size the greater probability we have of experiencing a 20 trade losing streak.

In a sample size of 900,000 trades at either a 50% win rate or even a 60% win rate, there's actually a 100% chance of experiencing a 20 trade losing streak. That's pretty high chances. It doesn't take a genius to now see that you need a system that can hold up to 20 consecutive losses in a row because it can happen, and EVENTUALLY it will given enough time.

Even in a sample size of 250 trades (a years worth of trades on average), the odds of experiencing a 10 trade losing streak is set at a hefty 45% even with a strategy that wins 60% of the time. There's a 4.3% chance of encountering a 15 trade losing streak and a 0.3% chance of encountering a 20 trade losing streak.


Now let's say I created a brand new, revolutionary strategy that trades twice a week. But I've only made 20 trades total. Even at 20 trades with a 60% probability of winning, I still have a 10% chance of getting a losing streak of 8 trades. 10% is quite high. And now factor in that beginner traders are also more likely to make mistakes and act on emotion, the lose rate will probably skyrocket in addition to our baseline statistic.

I ran a coin toss simulation at 60% probability for heads and in the very first run, here is what I got:

H, T, H, H, T, H, T, H, T, T, T, T, T, T, T, T, H, T, T, T

From this very first simulation, I had a 10% chance of scoring 8 loses in a row and I got it on my very first run. Quite remarkable.

So now let me take the results of this coin toss simulation (a direct representation of our trades where Heads is a Win and Tails is a Lose) and calculate our new win rate which is now at 30%.

60% ----> 30% in 3 weeks of trading.

You can see that this is a major difference and has major implications on your Risk/Reward, balance that's at risk, and of course your psychology. Say you risked 5% on each trade (as many ForexFactory traders suggest) and you have a "easy" 1:1 risk/reward ratio. Let's go through the break-down using our previous coin toss results:

100 + 5 - 5 + 5 + 5 - 5 + 5 - 5 + 5 - 5 - 5 - 5 - 5 - 5 - 5 - 5 - 5 + 5 - 5 - 5 - 5 = 55

1. You were hoping to make 70% gain on a 60% winning strategy.
2. But instead you're down 45% on a 30% winning strategy, you lost 45% of your account in 3 weeks!
3. You now give up trading for good OR go back to ForexFacotry looking for the 'Holy Grail' to make back your losses as quickly as possible.

This is how a lot of traders approach the game and this is the position they're in. We don't need to know advanced trigonometry or calculus, just basic math to understand this strategy doesn't add up!


Now let's change our strategy to one that incorporates better risk management overall. A strategy that let's our winners run and cuts our losses short.

This strategy wins 50% of the time and has an Average Win : Average Loss (Risk/Reward) of 1:3 and we only risk 1% of the account on each trade at all times (nothing less, nothing more). We use the same coin toss results to see how well our balance holds up:

100 + 3 - 1 + 3 + 3 - 1 + 3 - 1 + 3 - 1 -1 -1 -1 -1 -1 -1 -1 + 3 -1 - 1 -1 = 104

1. You were hoping to make 9% over the course of 3 weeks (12% in a month) on a 60% winning strategy.
2. Instead you had a bad month and only made 4% on a 30% winning strategy.
3. You now brush it off as a bad month and stick to your plan.

You continue on trading the same system and keep emotions out of your trading because you haven't lost anything. As you place an additional 20 trades, the randomness factor has decreased and your win rate approaches the baseline 60%, as expected. Next month's trading results look something like this:

T, H, H, H, T, H, H, T, H, T, T, H, T, H, T, H, H, H, H, T

...which translates to...

104 - 1 + 3 + 3 + 3 - 1 + 3 + 3 - 1 + 3 - 1 - 1 + 3 - 1 + 3 - 1 + 3 + 3 + 3 + 3 - 1 = 132

1. You're now up 32% using a 50% winning strategy, much more than you expected and more than enough to cover last month's slow growth.
2. You're excited and have built valuable knowledge on how risk management should work.
3. You will continue to profit as long as you don't deviate from your risk management rules, you will become a million after 9 years of hard work aiming for the same 12% a month and let the starting $10k balance compound each month.

Another added benefit in understanding how statistical probabilities can improve your trading is by working with these percentage deviations instead of against them. If you of aim for 25% growth in a month (the max your strategy can push to for example) you will let yourself down because even if your strategy really is 70% winning, statistical deviations and randomness will eventually cause you to have a bad week/month. You'll miss your target and become anxious and stressed, needing to make trades on impulse rather than on logic.

An alternative is that you should take the winning percentage of your strategy and run it through a simulation of weighted coin tosses (or trade simulator) in order to find the deviation amount and then factor those results into your % of balance at risk per trade and Risk/Reward. Make sure to aim on the low end. That way you can aim for 12% growth rather than 25% in a month and be pleasantly surprised when you make 30% one month and be content when you make 9% the next month.

Underpromise and overdeliver on yourself!

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This is why trading is a numbers game! Your strategy must be flexible to sustain 20 consecutive losses WITHOUT losing more than 40% of your balance. At a 40% loss, you're still able to recover if you maintain a 1:3 risk/reward (on average) with your trades. Going above the 40% mark makes it statistically hard to get back to your breakeven point!

Losing 20 trades consecutively at 1% risk per trade is a 20% loss. Even though you lost 20 trades consecutively, it only takes you 6 trades to get back to breakeven which is quite acceptable and doable. This is a factor of 1:3.33 where for every win, you recover 3.3 losses.

Losing 50 trades consecutively at 1% risk per trade is a 50% loss on account balance. After 50 losing trades consecutively, it'll take you 18 winning trades to hit breakeven. This is a factor of 1:2.7 where every win recovers 2.77 losses (even though our underlying strategy is still using a 1:3 risk/reward ratio for every trade; relative to our earlier balance we start seeing inefficiency building up).

With the the more consecutive losses you encounter the harder it is to recoup your earlier balance, eventually getting to a point where it becomes statistical unlikely. That mark is at 50% (and for beginners it's at 40% loss of account balance). This is why you should always select a % to risk per trade that is at 2% or under! If you're risking 2% per trade you have the ability to sustain 20 consecutive losses. At 1% risk you have the ability to sustain 50 consecutive losses before it becomes statistically unlikely that you'll recover using the same positive 1:3 risk/reward ratio.

When you start risking 3%, 4%, and 5% on each trade, you WILL fail when you start having clusters of bad trades and it'll make your trading extremely demanding when you need to revenge trade just to break even. At 5% risk on each trade, you only have 8 consecutive losses before you reach the unsustainable part of the equation. And from our earlier statistics, there's a 10% chance of running into 8 consecutive losses just from your first 20 trades alone! This is a very high chance and is part of the reason why many retail traders fail rather quickly on strategies that actually work! They use too much risk (overleverged) and then falter during clusters of (un)expected losses.

A 1 step back, 3 steps forward approach should be EVERY beginner's approach towards profitability. Along with a pre-defined % to risk on each trade. As we're not trying to be "great traders," we're trying to be "profitable traders."

The reason why I took the time to explain this is that when it comes to trading, nothing is left to chance. You must calculate the odds of hitting the odds and make sure your risk management plan is capable of handle the tough times. Doing so will allow you to survive and reduce your stress and emotion responses (an important topic for another thread).


Key Points

1. Alongside defining your trading style and if you're using a static or dynamic R/R, you must define your ratio amount and put it to a battery of math tests in order to survive consecutive losses and come out ahead, regardless if the strategy is 40% winning or 80% winning.
2. Once you stick to a R/R and a % of balance risk, do not deviate from it! Always stick to your plan!
3. When it comes to selecting growth targets, make sure to run simulations and see how well your risk management strategy holds up to randomness. Pick targets that are on the low-end of your growth possibilities so that you can underpromise and overdeliver on yourself.
4. 1:3 risk reward minimum + a MAX of 1-2% risk per trade will save you in the long. With these numbers, you will easily survive runs of 8-20 consecutive losses in a row (which will happen sooner than later) and still have ability to recover WITHOUT changing any part of your strategy or money management and help to keep your sanity in check.
5. If you experience more than 20 consecutive losses, it's time to take a break from trading and come back with a clearer head. Anything more starts becoming statistically unlikely according to the numbers!

More concepts to come!

Choosing an R:R is not always necessary or even possible. Many traders (especially classical trend followers) do not use profit targets either completely or at all. With a dynamic profit raking setup R:R is a historical average that may never be repeated. And thus testing for it in real data may be simply curve fitting.

That said I certainly see the value in trading with what is probable. If you need your currency pair to do something it has never done or has only done once every decade then you may have difficulty timing it and you will definitely have difficulty making consistent profits with it.

Something simple like: "EURUSD crossed the 8 day moving average 68 times in 2018 and 37 times YTD in 2019" is bit more tradable than "EURUSD broke the 100 day price channel 8 times in the last decade".

This is a Very good expect of trading(risk management), nice thread, I will surely contribute as time goes on.

Take a look...risk reward should match your winning percentage. Either it is at the percentage or higher.

Risk management is, in principle, one of the key laws of business, which ensures the safety of your capital and allows you to properly distribute it into parts that can be used in several business areas. I have my own rules, which I have been following for many years, and it is they that give me profit and allow me to find a quicker way out of any even the most crisis situation. First of all, I never put more than 10% of my capital into operation. Secondly, I try never to allow more than 12-15% of my capital to drawdown. Thirdly, I never grab dozens of assets, preferring to concentrate on 4-5 to make my profit justified and my work structured.

An important factor to focus on in risk management is understanding the directed exposures of your positions.

If your account is in position EURUSD 2.2x-equity and your denominated in USD and you have a take-profit-limit set at 1.15 then you have 2.2x volatility of EURUSD spot rates as well as another 1x volatility in US Dollar exposure after the trade closes and the 2.2x EURUSD volatility vanishes.

and just like that, 2020 happened

This is true IF you go for WIN TP or SL case...
Situation mechanical, trader no needed.

Once I had a trade closer ea. It was a free ware and I somehow manage to lose it. I recall at a basket profit of $930 I opted to close all trades immediately. It just would not do anything. I removed it and replugged it. Same thing. But after about 10 minutes it closed all trades at once at total $1190 profit. To this day I wonder what was the exit strategy. Was it trailing exit or break even exit strategy. I had never seen such a sensational trade closer before. Any comments about the closing strategy. Thanks in advance.