When trading currencies, managing your risk is extremely important as the leverage can cut both ways. You may find that your winnings are accelerated, but very few people pay attention to the fact that their losses are accelerated as well by the very leverage that attracted them to Forex in the first place.
When we are first introduced to the world of Forex trading, from one of the first things that we hear is how outrageous returns can be. While this is true, is very unrealistic. We will often hear advertisements that tout outrageous gains like 50% in one week. We start trading for a while, and suddenly will reality sets in as we understand that these gains are not sustainable. Now that reality has set in, let's take a look at how a prudent trader goes about discovering how to control their risk in the Forex market.
While this may sound like heresy to some of the self-appointed Forex gurus out there, many professional Forex traders will not risk more than 1% of their account on any particular trade. While this doesn't sound like much, you have to remember that typically you are aiming for more than you are risking. A typical two-for-one strategy would have you aiming at 2% gains on every trade. Besides, look at all of the people that Bernie Madoff managed to swindle billions from by merely offering 1% a month! You have to ask yourself, are these people stupid? Or is it possible that they were blinded by "excellent gains?” To understand the appeal of this, you have to understand compound interest.
Using Bernie's example of 1% gains per month, you end up with a tidy 12.68% return per year. While this doesn't sound like much, this sets up for you to triple your account in 10 years. While this doesn’t sound like much, I can assure you that many people are willing to take that gain. What happens if you bump up your returns to 15% a month? You now have tripled your account in 8 years. With a starting balance of just $10,000 you will end up with $40,455.58 at the end of the decade. Again, these are very conservative returns. A good Forex trader might get something closer to 25% a month. Your $10,000 turns into $93,132.26 after 10 years. These are great returns as you can see.
By only risking a small amount, you allow yourself to stay in the game after a couple of losses. If you are only risking 1% on a trade, losing three trades in a row is actually less than 3% of your original balance. Risking 5% on the same trades, you find yourself down about 13%. But whole would you rather dig out of?
By seeing what compound interest can do, you must understand that it works both ways as well. By risking small amounts on each trade, you allow yourself to grow your account, and just as importantly - gain experience to become a better trader. After all, if you are broke and your account is blown up, you are trading.
The best way to gauge which amount to risk on any particular trade is to notice your psychological reaction when placing these trades. If you feel that you have to absolutely sit and babysit the trade, you are more than likely risking more than you are psychologically comfortable with. While this doesn't change the math, it does affect whether or not you exit when your system tells you to, or when you simply can't take the pressure anymore. As a litmus test, I have found that if I cannot walk away from the computer with the amount I am trading running live, it's too much. Besides, the whole idea behind trading is to make money without worrying about it. Remember, you started trading for the idea of freedom. And that freedom certainly wasn't sitting at a computer worrying about losing a particular trade.
By experimenting with various percentages of your trading account, you will find what works for you over time. You'll be surprised at the gains that you can get with even the smallest amount of risk being placed. If you learn to trade correctly, the gains will come. But you have to be able to stay in the game long enough to get to that point.
By: Christopher Lewis
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