• "Risk comes from not knowing what you are doing" - Warren Buffett

  • "Good money management alone isn't going to increase your edge at
    all. If your system is not good enough, you are going to still lose money, no
    matter how effective your money management rules are. But if you have an
    approach that makes money, then money management can make the difference
    between success and failure.
     - Monroe Trout

  • There are many trading quotes out there from very successful billionaires such as these aforementioned two, centred around the concept of risk management and controlling your total exposure - there must be a reason for the successful traders to go on an on about this crucial aspect to any and all trade plans.

  • Risk management is all about limiting your total, worst case, losses in the market at any given time. Before we explore some of the key ideas to follow you must remember the safest, most liquid and lowest risk level of market exposure is no exposure, in other words no open positions and fully cash.

  • One key point to remember is that Risk management can come in many forms; 
  1. A Dollar amount - Such as the feature operated by Dukascopy to close ALL positions after there is a open loss of a pre-determined amount.
  2. A pip Amount - Whereby, through your strategy you employ a use of 20 / 50 / 100 pip stop on all your positions regardless of position size and trade duration.
  3. A % risk - The commonly quoted figures of 1 - 2% risk to your account at any one time in the market.

Depending on the trader and his tolerance to risk he will use one of these styles.

Retail level

  • There are of course advantages to each of these, but it is important to use at least one of these, There are many out there who do very short term trades on pairs like NZDUSD or AUDUSD and go for 5 pips and no stop loss, this strategy works well in normal conditions and you can gain serious profit.

  • But.... and there is always a but, days where some shocking news comes out or there are some serious problems like Aug 2011 or 2008/09 when this strategy WILL fail, when you have a 200 pip stop and 5 pip target you are going to win 99.5% of your trades but its that one trade that will wipe you out.

  • It must be understood that to gain in trading and in life you must take risk, it is impossible to improve otherwise. This concept is tightly woven with the Commonly Used Risk:Reward ratio.

  • If you were to target 100 pips and only risk 50 then you would have Risk:Reward of 1:2, simple.  But you need to factor your expectancy to win or your win-loss ratio.

  • Once you have worked out these two figures you can accurately figure out how much you should be profiting or losing. From here you can tweak your risk:reward to accompany more gains.
  • As you can see there is a severe trade off between winning and having a high win-loss. As a trader you need to decide which works best for you. Personally I look for greater than 80% trades with a risk:reward of 2:1.

Institutional level:

  • Traders and investors for large banks and financial institutions use much more complicated measures using complex derivatives to protect their investments such as the recent problems faced by J.P. Morgan with a trader hedging himself incorrectly by using CDS' as seen here.

  • Typically to protect themselves or lower risk some traders will have portfolio's which can have components that protect other parts. Using a calculation of "beta" a trader can see how much X has moved in comparison to Y, with Y normally being a index such as the Dow Jones Industrial or S&P500 and X being a volatile stock. 

  • Traditionally portfolio's have looked like this,

  • Personally however mine looks like this:

DJIA - 25%
US 5YR - 15%
Gold - 25%
USDJPY - 10%
US 10 YR - 15%
High beta - 10%

  • For me, high beta includes hand picked stocks that tend to do very well in good times, I would trade this basket of goods in such a way that if I saw a fall coming I would transfer the DJIA and High beta into cash and maintain the other positions.

  • It is commonly seen that many professional traders hedge, made famous by the hedge funds that earn a lot of money and are normally successful. However in the forex markets, hedging is widely unavailable to retail traders. Many will Buy EURUSD and Sell GBPUSD and they may see themselves as hedged but they have merely bought EURGBP.

Conclusion:

  • Regardless of whether you are a retail or institutional trader you will have to consider capital preservation at all times and make sure you are protected and prepared for anything, as always
"Hope for the best, Prepare for the worst"


Thanks,

Adrian.