Forex Risk and Money Management Part 2.

In the Forex Risk and Money Management Part 1 you could read about the types of risks and now in the Part 2 you will learn how to manage the forex risk and variance properly. If you have not read the first part yet, I recommend to start with that, then continue with this article.

Trading volume and maximal drawdown

Impact of Risk / Reward and Win ratio

–          First of all, it is important to understand that choosing a proper trading volume depends on Risk / Reward and on Win ratio. Let’s assume, that you have 1 : 1 Risk / Reward and 90% Win ratio. Why should you use the same trading volume as if we have 50% Win ratio, while you would expect much smaller drawdown? To maximize your profit you should determine the maximum drawdown that you can handle with ease, then choose the right trading volume. With this trading volume you will rarely exceed the maximal drawdown that you have determined before.

Your Equity

You have to calculate your average equity on a trade first. You can do this in two ways:

–          Take all of your gainings and divide with the sum of your gainings and the absolute value of your losses. The received number will be your equity on a trade. 0.5 or 50% means that you will win and lose one unit in 50%, so you will not make profit. For example: All of your gainings on your trades are $6000, and your losses are $4000. That is, $6000 / ( $6000 + $4000) = 0.6 or 60% is your equity.

–          Take your Risk / Reward rate and your Win ratio. Multiply your Reward value with your Win ratio and divide with the sum of Reward * Win ratio and Risk * (1 – Win ratio). For example: Your Risk / Reward rate is 1 : 4, and your Win ratio is 25%. So, 4 * 0.25 / (4 * 0.25 + 1 * 0.75) = 1 / 1.75 = 0.57 or 57%.

Note: You must have a big sample to count your equity accurate.

Expected drawdown

You can see your average expected maximal drawdown below on a trading sample of 1000 where the rows mean your equity on a trade and the columns mean the percentage of your capital that you risk in a trade.

Average drawdown depending on risk (column) and on equity on a trade (row)

 

On the table above you can see, that the more equity you have on a trade, the more percentage you can risk of your capital with the same expected drawdown. Hence, if you have big equity on your trades, you can maximise your profits with increasing the amount of risk.

How to choose your trading volume?

Above you could see, how much percentage of your trading capital you may risk. But how to calculate your trading volume? It depends on your trading capital and on your stop loss in pip.

–          Let’s assume, that your equity is 54%, so you would like to risk 2%.

–          Let’s assume, that your capital is $10000. So $10000 * 2% = $200. This will be the amount that you will risk.

–          Let’s assume, that your stop loss is 25 pip. On EUR/USD 1 pip value is $10 per lot, but you will only risk $200 / 25 pip = $8 / pip, so you can trade with $8 / $10 = 0.8 lot.

–          Another example: if you are using 40 pip stop loss, than you can risk $200 / 40 pip = $5 / pip. But if you can only risk $5 per pip, and 1 lot value is $10 per pip, than you can only trade with $5 / $10 = 0.5 lot.

It is important to understand, how to calculate your trading volume, but you can also use position size calculator to make easier to count.

What if your Risk / Reward rate is 1:5 or 5:1?

If your Risk / Reward rate is 1:5 that means that you have much smaller stop losses than take-profits. For example 10 pip stop loss and 50 pip take-profit. It is not hard to see that if you are still risking 2% of your capital than you have to expect much more variance. Therefore, you should reduce your risks to avoid larger drawdowns.

You can calculate your expected variance growth or reduction with a simple formula, which is 2 * Reward / (Risk + Reward).

If your Risk / Reward rate is 1:5, than 2 * 5 / (1 + 5) is 1.67. That means, that you can expect 67% more variance compared to 1:1 Risk / Reward rate. Therefore you should change your stop loss too.

For Example: You have 60% expected value on a trade, and you decided to risk 3%. But you are using 1:5 Risk / Reward ratio, ergo you should only risk 3% / 1.67 = 1.8% of your capital. (That also means, that you will win 9% with a winning trade).

In the table below you can see, how much of your trading capital you should risk depending on your expected value (row) and on your Risk / Reward ratio (column) if your average maximal drawdown will be 30% on a trading sample of 1000.

Recommended risk rate depending on your Risk:Reward and on your Equity