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Traders: Practice Safe FX
Education | 15 May 2013
By: Stuart McPhee
Articles (22) Profile

FX Protect yourself as a forex trader by following sound risk management rules

Many people fail to meet their own performance expectations in the markets because they do not employ sound risk management rules. The hard truth is that risk management will make or break you as a trader.

Proper risk management rules are well known and have been proven through years of use by traders everywhere. For example, the rules ‘keep your trades small’ and ‘never average down’ (adding more money to a losing trade) are timeless principles, yet many people ignore them.

Why? Money affects people’s emotions. The main reason most people trade is to acquire money, yet this very mindset is what sets them up for failure.

Everything you do as a trader should be done to protect your trading capital and not to simply make money. For example, cutting your losses should be one of the most important rules in your trading plan. However most traders whose primary focus is making money find this incredibly difficult to do because chalking up a loss goes against their purpose.

Why Size Matters
Someone with a method to guarantee that 80 percent of their trades are profitable could still lose money due to poor risk management. Meanwhile, another person’s trading method might have only a 30 percent success rate, yet they could still make money consistently. How can this be?

It depends on the size of the losses compared to the size of the profits. People who make a profit in 80 percent of their trades may incur losses far greater than all the profits they achieve. Similarly, people who realise a profit in only 30 percent of their trades may achieve substantial profits and keep all of their losing trades relatively small in size.

Within reasonable limits, it almost doesn’t matter how many of your trades are profitable when you employ sound risk management principles.

This can be seen in the image, which graphically depicts the change in account balance (starting with $20,000) through ten trades – eight winning trades and only two losing trades. Despite the 80 percent strike rate, the trader in this example has still lost almost half their starting capital due to the relative size of the profits and losses. Herein lies the key: it’s not how often you get it right and wrong; it’s what happens when you get it right and wrong.

A related subject is expectancy, which in simple terms is the average amount you can expect to win (or lose) per dollar at risk. This incorporates your potential reward with risk in every trade and is an often-overlooked component of risk management.

Common guidance from experienced traders is to spend less time on your entry signals and more time developing a sound risk management plan. Your ability to manage risk will make or break you as a trader.

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Stuart has more than 16 years of trading experience under his belt and specialises in technical market analysis of major currency pairs. Apart from being the author of several bestselling trading books, with his most recently released book "Trading in a Nutshell", Stuart contributes to daily newletters and blogs. He also produces articles and videos on the how tos of technical tradings. For more information of Stuart, you can follow him on twitter @stuartmcphee or check him out on Google+.

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