Ways to manage risk: part two

We've looked at some general methods of managing your risk, now here are two practical techniques you can use to work out exactly how much risk you should be taking on with each trade.

Calculate your maximum risk per trade

Choosing how much to risk per trade is all about your personal circumstances. You'll find some guidance that says don't risk more than 1% of your trading capital per trade, while others say it's ok to go up to 10%. Most traders agree not to go much higher than that though, and here's why...

If you go on a big losing streak, the amount you're risking per trade will have a huge effect on your capital and the ability to claw back your losses. Say you've got $10,000 of trading capital and you're unlucky enough to lose 15 trades in a row. Here's the difference between risking 2%, 5% or 10% per trade:

• With 2% risk per trade, even after 15 losses you've lost less than 25% of your trading capital. It's conceivable that you can win this money back.
• However, if you'd gone for 5% risk per trade, you'd have lost over half your initial trading capital. You'd have to more than double this amount to get to your original level.
• With 10% risk per trade, things are even worse. You'd be down over 75% making it extremely difficult to make back the money you've lost.

The reduction of capital after a series of losing trades is called a drawdown. It's important to work out what percentage drawdown will make it difficult to reach your trading goals, and then ensure your maximum risk per trade is in line with that.

Based on this information, you can also work out a risk-per-trade scale. If you're an active trader who only places a few trades every day/week, then the scale might look like this:

Of course, if you're a long-term investor only making a few select share trades per year, then 10% risk per trade might make complete sense. But if you're a high-frequency forex trader making over a hundred transactions per day, then even 2% per trade could be far too high. It all depends on you and how you like to trade.

Remember, all traders will be affected by a losing streak at some stage, but the ones who plan their trading to cope with those streaks are usually more successful in the long run.

Work out the risk vs reward ratio of every trade

It is possible to lose more times than you win, yet be consistently profitable. It's all down to risk vs reward.

To find the ratio on a particular trade, simply compare the amount of money you're risking to the potential gain. So if your maximum potential loss on a trade is $200 and the maximum potential gain is $600, then the risk vs reward ratio is 1:3.

If, for example, you placed ten trades with this ratio and you were successful on just three of those trades, your profit and loss figures might look like this:

Over ten trades you could have made $400, despite only being right 30% of the time. That's why many traders like to stick to a risk/reward ratio of 1:3 or better.

A word of warning though – if you're taking on less risk for a greater potential reward, it's likely the market will have to move further in your favour to reach your maximum profit, than it will to hit your maximum loss.

So, in the above example, the market would probably have to move three times as far in your favour to reach a $600 profit, than it would have to move against you to cause a $200 loss.