LESSON 5
Money and Risk Management
- Money management is managing unrealized profits whereas risk management is managing the open positions
- Remember, never risk more than 2% of your account on any single trade. You may use variable position sizing with these systems and vary your position size depending on your stop loss such that you risk only 2% of your account.
- Before trading on real account, please do some paper trading or trading on demo account first, until you are really confident with the system, then you can switch to trade on your real account. Here are some points you can practice when you do paper trading:
- Plan on paper trading for 3-4 wee
- Trade the same size you would if you were trading with real money.
- Record all trades made carefully so you gather more experience
- Always use stop
- Diversify your portfolios by trading different pairs of currency
- Adding money to winning trade not losing trade
Learning your risk tolerance
Every trader needs to access how much risk they can comfortably handle. The fact is many people either do not have a clue how or don’t feel they need to protect themselves from unnecessary risk.
We will review the various types of risk and proper risk management to maximize your personal performance which includes;
- What is risk?
- The different types of risk
- The risk/return balance
- What is risk?
For most investors risk simply means “losing money”
The dictionary definition of risk is “the variability of returns from an investment or the chance that an investments return will be different than expected”.
- Different types of risk
There are two basic classifications of risk:
- Systematic risk
A risk that influences a large number of currency pairs e.g. global political events, natural disasters or war.
- Unsystematic risk
Also referred to as “specific risk”. It affects a very small number of currencies and currency pairs e.g. a sudden strike by employees or a change in the Canadian interest rate.
- A closer look at the specific types of risk:
(a) Default risk
This is the risk that the company with whom you have forex trading account will be unable to pay out an investor’s account balance when a withdrawal request is submitted.
*Choosing a suitable stable broker is more than choosing the biggest
(b) Country risk
This refers to the risk that a country won’t be able to honor its financial commitments.
Most often seen in emerging markets or countries that have a severe deficit
(c) Foreign exchange risk
When investing in foreign currencies you must consider that the currency exchange rate fluctuates.
(d) Interest rate risk
A rise or decline in interest rate during the term a trade is open will affect the amount of interest you might pay a day until the trade is closed.
*Consult your broker for complete details of their policy including time of roll-over, interest price (also called swap) and account requirement to receive an interest paid to your accounts.
(e) Political/economic risk
This represents that a country’s economic or political event will cause immediate and drastic changes in the currency prices associated with that country e.g. the government intervention we see with Japan and the need to maintain low currency prices to bolster their exports.
(f) Market risk
It is the most familiar risk. It is the day to day fluctuations in a currency pair’s price; also referred to as volatility.
Volatility is a measure of risk because it refers to the behavior or “temperament” of your investment rather than the reason for this behavior.
(g) Technology risk
With majority of individual forex traders executing trades on line, we are all technology reliant.
Are you protected against technology failure?
Do you have an alternative internet service?
Do you have back-up computers that you could use if your primary trading computer crashes?
Risk/Return balance
This is the balance a trader must decide on between the lowest possible risk for the highest possible return.
Remember to keep in mind that low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns.
Trading is all about risk and probabilities
TRADING PLAN
Think of your trading plan as your map to success. It will be a constant reminder of how you will make money in this market. Of course it is not required, and if you can make your living by trading without a plan, we will bow down and hail you as the Market Zeus of the forex.
Why have a trading plan?
Reason 1: It keeps you in the right direction
Consistency is very important to have in your trading routine because it allows you to truly measure how successful you are as a trader. If you have a sound trading system but always break your rules, how can you ever really know how good your system really is? Your trading plan will keep you on target. Read it everyday and stick to it.
Reason 2: Any successful business must have a plan
Whether by luck or experience, anyone can make money in forex. However, the difference between a losing trader and a successful one is in the PLAN! If you have a trading plan and be disciplined enough to follow it, you will succeed.
What to include in the trading plan:
- What kind of trader you will be
- Currencies to be traded
- Risk (amount you are willing to risk per trade)
- Time frames to use
- Indicators (a) to establish new trends (b) confirm trends
- What to consider when going (a) Long (b) Short
- How and when to enter/exit market (resistance or support)
- Also indicate (a) how you will keep your journal (b) your goals (c) your vision
In summary
- A trading system
Your trading plan
- Trading routine
This will depend on whether you are full time or part time trader.
- Mindset
This describes your emotions when trading.
You will see what is on the charts not what you want to see.
Don’t take “revenge” on the market if it goes against you.
Don’t beat yourself up if you make a losing trade, instead take it as a learning experience and move on.
- Your weaknesses
We all have our weaknesses
Examples:
- Overtrading; after losing/gaining a lot of money you continue to trade.
- Exit early on the trades
- Not following the trading plan
- Not sticking to your money management plan
- Your goals
Think seriously about what you want to accomplish as a trader. Do you want to trade for a living? How much return can you realistically expect from trading based on your knowledge and experience? Your goals need not even have to be about making money. Maybe you would like to be more disciplined or gain confidence.
Goals can be personal. What do you really want to get out of this? Use these goals as your motivation when times get tough. These goals will be your vision and you must always keep your eyes on the prize!
- Your trading journal
Benefits of keeping a journal
- Defining yourself and your situation in life
- Keeping progress of your goals you’ve set in your Trading Plan
- Clarifying your weaknesses and strengths in your ability to perform and handle pressure
- Providing a way to self-coach and improve on your own
Here’s some final advice to keeping a helpful trading journal:
- Always begin the journal before the trade, and end it after the trade.
- Write down everything. Don’t leave anything out. Be honest. If you decided to play Call of Duty while you were in a trade and forgot to exit your trade, write that down, and explain why. Later down the road you can look back and evaluate your trades and see your progress
- Pay very close attention to your emotions. Then make sure you write them down.
- Make sure the journal includes observations about you and your trading and about the forex market. Trading journals are usually skewed toward self-analysis and include little in the way of market observation. Take a screenshot of intraday charts of each day’s action and write comments on them. Make note of patterns that you are watching for. After a couple of months, you will start to see the patterns emerging in real time. The trading journal is a learning tool and a great mechanism for training your eye to see the setups you want to be trading.
- Nothing is too silly to record inside your journal. Write it down. Write down whether you missed a trade because you were watching the latest episode of Friends, or playing Modern Warfare 2 or you were busy talking to your sweetheart. Write it all down!
- If you lose or gain a trade you must understand why it has happened i.e. what were the technical and fundamental responsible.