Understanding risk and reward
Controlling risk
Following the first three rules will begin to help you manage risk in your trading activities. But these steps alone won't protect you from the risk that a single bad trade could wipe out your trading account if you risk too much on any one idea.
So it's important to consider the amount of risk you're accepting on each and every trade.
Rule 4: control your risk amount per trade
Suppose you open a trade on EUR/USD, setting a protective stop-loss order at 100 pips and a limit 200 pips away. Could you still blow up your account?
Yes, absolutely. If a move of 100 pips equates to 50% or more of your trading account, just that one trade could erase a significant portion of your equity if things go wrong.
Example
Let's go back to the coin flip game in the last lesson. Suppose you hit a run of bad luck and lose five consecutive flips.
What happens if each successive flip erases 50% of your remaining equity?
Say you start with £10,000 in equity. After five flips you'll only have £625 remaining. That's a net drawdown of 93.75%, all because of five cases of bad luck.
To get back to your original £10,000, you'd need to generate a return of 15,000%, since you're now starting from such a small base. Unfortunately this isn't likely to happen.
You can avoid this situation by controlling the risk amount on each individual trade setup.
Many professional traders will keep their risk amount per individual trade idea to less than 1% of their account equity. That way, if any given trade idea doesn't work out, the most they stand to lose from it will still leave them with 99% or more of their account equity intact.
So if your trading capital was £10,000, you'd risk no more than £100 per trade. That way, if you had an unlucky run of five successive losses, you'd still be left with a healthy £9500 in your account.
Question
Suppose you decide to risk 1% of your trading capital on each position. How much profit should you aim to make per trade, as a percentage of your trading capital?Correct
Incorrect
If you risk 1% per trade with the recommended 1:2 risk vs reward ratio, you can potentially make 2% of your trading capital if the trade works out. For newer traders it's a good idea to start with smaller amounts; but at no time should you risk more than 5% on any given idea. Frankly, markets are unpredictable, and even the most carefully planned trade by the most experienced trader can go wrong.For newer traders it's a good idea to start with smaller amounts; but at no time should you risk more than 5% on any given idea. Frankly, markets are unpredictable, and even the most carefully planned trade by the most experienced trader can go wrong.
Homework
If you have any trades in progress at the moment, check to see if your risk vs reward ratio is 1:2 or higher.
What percentage of your trading capital is at risk on each position, and are you comfortable that you could tolerate this level of loss if the unexpected happens?
Lesson summary
- A single bad trade could wipe out your capital if you accept excessive risk
- Control the amount of risk you take on each trade
- Risk no more than 1-5% of your trading capital on any single idea
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