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Basics Of Risk And Money Management

Protecting the capital you have and being able to come back to your trading platform tomorrow is often more important than trying to make a lot of money. Therefore, risk and money management plays a very important role in trading. By making sure that you cannot lose too much money on a single trade and that, over the long-term, your winners will outweigh your losers, a trader can avoid some of the common and costly trading mistakes.

 

What is a stop loss and how to use it effectively

A stop loss is the most important tool, especially when you are starting out. A stop loss can prevent large losses and it helps you to determine your position size very accurately.

 

Do brokers hunt stops?

Some traders argue that brokers hunt stops and that trading without a stop loss is more profitable. Keep in mind, if your broker is a no dealing desk (read more about broker types here), your broker just passes your orders through to a liquidity provider and they do not even actively trade most of the time. Furthermore, if you are trading with a well regulated broker, they have to adhere to certain rules and cannot artificially manipulate prices. And finally, brokers earn their lion’s share through their clients’ commissions and, therefore, have an interest to keep you around or some time.

Do not make the common beginners mistake to not use stop loss orders because of one of those myths. A stop loss should be your most important tool that saves you in bad times.

 

Position Sizing

With your stop loss, you can determine your position size and how much you are willing to risk on any single trade. Without a stop loss, pre-determining your risk and the size of your trade is impossible. As you can see, a stop loss is a very useful tool.

Determining your position size is a 3 step process:

 

Step 1: Find reasonable places for your entry and your stop loss order

Most traders first determine how much they are willing to lose and then look for the price where to place their stops. In reality, you should look for a level to place your stop loss level at that makes sense for your trade. Choose a place where markets prove your trade idea wrong and where you want to be out of the trade. You should not adjust the distance of your stop loss order to match it to your position size.

 

Step 2: Measure the distance between your entry price and your stop loss order

Now, that you have identified a price level for your stop loss order, measure the distance between the entry price and the stop loss order.

 

Step 3: Calculate how many shares, contracts or lots you have to buy

Let’s illustrate the calculation for how many contracts or shares you have to buy for both, stock ad forex trading.

Stock: If you want to buy at $50.10  and your stop loss goes at $46.80, the distance between these two orders is ($50.10 – $46.80) $3.30. If your trading account is currently $10,000 and you want to risk 1% ($100) on that trade, you have to buy 30 shares ($100/$3.30).

You can use the position sizing calculator of our partner site Edgewonk to do it automatically.

 

Reward:Risk Ratio – the basics

[sociallocker id=”16666″]Now, let’s take a look the take profit order and what information we get from it. First and foremost, a take profit order is the price where your trade will be closed for a profit once price reaches the order. But there is more to it.

By analyzing the ratio between potential loss and potential profit, a trader can calculate his Reward:Risk ratio. A trade with an entry at $50, a stop loss at $48 and a take profit at $54 has a Reward:Risk ratio of 2:1 – the potential reward ($4) is twice as high as the potential loss ($2).

 

Profit
The ratio between take profit order (potential profit) and the stop loss order (potential risk) is also called the reward:risk ratio.

 

We will come back to this concept later in the advanced risk management section, because there are many more things to consider and when it comes to evaluating the Reward:Risk ratio – and a variety of benefits that a trade can retrieve by understanding how to use this concept. [/sociallocker]

 

 

 R-multiple

The concept of R-Multiple is just another way of looking at Reward:Risk ratio. R-multiple stands for “Risk” multiple. When using R-multiple, a trader quantifies the distance between his entry price and his stop loss price as 1R (1 R-multiple). The potential profit (the distance between his entry and his take profit) is then measured as a multiple of 1R – in this case the take profit is twice the size of the possible risk which translates to 2R. The screenshot below illustrates the concept.

 

R-Multiple

 

2 basic money management techniques

Although there are many more money management techniques that a trader can use, especially in the beginning, it is sufficient to familiarize yourself with the following two concepts. We will explore more advanced techniques later.

 

Fixed amount of money

You determine how much money you are willing to risk on any single trade. You then apply this position size to all your trades until you either move to a higher amount of money per trade or lower.

Remarks: If your account balance goes up, your position size (in percentage) will decrease if you stick to the fixed money approach. On the other hand, in a drawdown, your position size will increase in relative terms.

 

Examples - Fixed Position Size

Examples - Fixed Position Size

Account Balance Money Risked % of current account balance Outcome
10,000 200 2% Winner (1.5 times risk) (1.5 times risk)
10,300 200 1.94% Winner (1.5 times risk)
10,600 200 1.89% Winner (1.5 times risk)
10,900 200 1.83%

In a winning streak, the position size in terms of % decreases and grows slower when using the fixed money technique.

 

Account Balance Money Risked % of current account balance Outcome
10,000 200 2% Loser
9,800 200 2,04% Loser
9,600 200 2,08% Loser
9,400 200 2,13% Loser

In a losing streak, the position size in terms of % increases and shrinks faster when using the fixed money technique.

Fixed percentage

You set a percentage amount of your trading account and use it as a position size on your trades. The fixed percentage amount should ideally not exceed 3% and, at best between 1% and 2% if you are new to trading.

Remarks: You always risk the same amount in relation to your capital. Therefore, over time, all trades have the same weight and by constantly adjusting the real money amount, your account growth will be much more stable.

 

Example - Fixed Percentage

Example - Fixed Percentage

Account Balance Money Risked % of current account balance Outcome
10,000 200 2% Winner (1.5 times risk)
10,300 206 2% Winner (1.5 times risk)
10,609 212 2% Winner (1.5 times risk)
10,927 218 2%

In a winning streak, the account grows faster using the fixed % technique. Over time, this can amount to significant amounts.

 

Account Balance Money Risked % of current account balance Outcome
10,000 200 2% Loser
9,800 196 2% Loser
9,604 192 2% Loser
9,411 188 2%

In a losing streak, the account shrinks slower than when using the fixed money technique. 

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