If money management is primarily
directed to maximization of making a profit, then risk management - to minimize
the disbenefit. Below we will consider these two aspects in more details.
Control over risk is an
essential part of successful trading. Effective risk management requires not
only a close examination of risk proportion but also the strategy of
minimizing losses. Understanding that how to control the risk proportion
allows the newbie or experienced trader to continue the trading even when the
contingent losses are arising.
As each deal is exposed to a certain degree of risk, the application of definite general principles of risk
management will reduce the potential loss. Some of the adopted axioms of risk
control are described below and can be in use by all who has ever traded or
thinks about it.
1. Do a preliminary homework
To do the homework before the
deal is a responsibility that can never be replaced. Before you expose your
money to risk, you should have a good, thought—out the reason why you want to buy
something that someone wants to sell.
You should be clearly aware of which financial risk you may be confronted with at any time. The part of
homework includes an estimation of potential loss, in case if the market starts
moving against you by 5%, 10% or 20%.
Doing preliminary homework on trade can
also help you to work out the worst possible result, potential exposure to
risk. You can reduce the risk, if you restrict the number of deals, to carry
out the examining operation of which you can do (this is the carrying out of
your preliminary homework).
2. Create a trading plan and observe it
Every trader should create his/her own trading
methodology. The methodology or trading model can be based on the fundamental,
technical indicators or on a combination of both. The methodology should be
tested and processed while then it does
not show the required and long-term positive result.
Before you invest money,
make sure that your trading methodology is reasonable and profitable. An
important part of your trading plan consists of making limits to the amount
of money you can lose. If you reach this limit, come out of the position. Observe
your trading plan and waive the impulsive deals.
If you do not follow the plan,
then you do not have it.
The trading plan helps you to
identify and evaluate the key factors which have an impact on your deals and
may be an important educational tool for future deals. A reasonable trading plan will also inspire you with an
essential sense of confidence.
At the same time, it is unlikely that, having in
possession a definite plan, you will trade impulsively. However, you should not
blindly follow the trading plan. If you do not understand how the market acts or
your emotional balance is slightly broken, then you should close all positions.
Creating your own trading strategy, do not invest on basis of the market advice
or rumours. Your money will be at risk. Before starting to trade, do the preliminary homework and think over your own
deals verification.
3. Diversify
Risk portfolio is reduced by diversification. Do
not invest all the money in one deal. Diversify the amount of risk, trading at
one position, not more than 5% - 10% of your capital assets. To be effective,
the diversification must include the tools according to which you will find out
the correlation (namely, how the prices of those tools are moving at the same
time).
If you are in a long position on the EUR/USD, in a short one on the USD/CHF, then in fact you do not have
two positions. Indeed, these tools are highly correlated (the value of their
price movements are very similar), in fact, you have one position with double
risk. This is essentially the same as two positions on one of these markets.
Closely check the relationships between all your positions, rebalance and
check for errors in your portfolio. Pre-determined stop-orders restrict the size
of the risk and reduce your losses at the fast-moving markets.
4. Do not invest all your
money
Before finishing the deal,
make sure that you have a fair capital asset to pay compensation for an
unexpected loss. If a possible deal suddenly seems to be profitable, then
perhaps you are too optimistic. Usually, markets are rarely as good as they
might seem at the first glance.
If the market suddenly turns down, then it is reasonable
to have certain capital in hand to compensate for modest losses or margin call.
A certain capital, segregated for additional purchases, reduces stress and
lowers the necessity to assume extraneous risks.
5. Use stop-orders
Pre-defined stop - orders
restrict the risk rate and reduce your losses at the fast-changing markets.
Take a strict rule of stop-loss, for example, get out of the position quickly
if you lose 5% -7%. Even the most experienced traders, saying nothing of the lucky ones, use stop - orders to limit the
risk rate.
Undertake the obligation to get out the trades, if your plan does
not work. Stop-signals are needed to protect you. Use them when you start
trading. Some traders use stop-signals according to the time.
If the market behaves
itself as you have not expected, come out of the market, even if you do not lose
money. Stop-signals using in time are a reminder that you must come out from
the market if you are not sure what is actually happening at the market.
6. Trade according to the trend
It is unlikely that you will
suffer a loss if you follow the market trend. The market direction does not
matter as long as you have an open position on appeared trend. If you open a
failed position, then you will have to systematically reduce the risk rate.
7. Concede the error
probability and incur losses
An important aspect of risk
control is the ability to admit that you are wrong and come out of the game
quickly, even if it means losing money. Indeed, the best traders suffer losses
from time to time. But we all hate to admit our mistakes, so it is difficult to
follow this rule. The axiom is simple: let the profit bunch and reduce the
losses. Try to decrease the risk rate, if the market moves against you.
Do not
add to a losing position, hoping to compensate for a loss. If you do not
understand what the market is doing, come out of the deal. Also, you do not have to
conclude another deal immediately after a losing one with a view to draw back
the losses, firstly it is necessary to cool feelings.
8. Trade with taking
protective measures
One trader suggested a great
idea about the trade-in football terms: "The most important rule of
trading is to play superbly in defence, but not great in attack." Think
first about what you can lose and compare it with a possible prize. It is
better to take into account the possibility of negative events development in
advance and make a plan than to change everything after the happened fact.
Always admit the idea that the market can start moving against you and be ready
for this in advance. Calculate the maximum possible usage of the credit. If it
is necessary, correct the stop — signal levels where it is more suitable.
Create a plan of coming out from the market. So, when the market starts to move
against you, you will be ready for it. Protect what you have.
9. Do not trade too much
Reduce the risk by decreasing
the amount of making deals and maintaining small stakes. Be critical to the
risks to which you are exposed. Limit the number of deals by one of them,
which is the most attractive. This forces you to do preliminary homework and
reduce the risk to make impulsive and emotional transactions. Since the
number of deals will be less, you will be more patient. Fortunately, a smaller number
of transactions also reduce the amount of commission you pay.
10. Have control over your
emotions
All traders from time to time
go through severe stress and suffer losses. Anxiety, frustration, depression
and sometimes despair are part of the market trading. A part of risk
management makes the ability to control these emotions. Do not let emotions
control your trading. Focus on what you are doing. Trade on the basis of
informed, rational decisions, instead of emotions and fantasies.
Communication
with other traders is one of the ways to maintain control over your
emotions. Other traders understand the challenges you have faced and can
provide important emotional support when you have no courage. It helps you
to understand that you are not alone and that others faced with similar
problems and had rubbed through them.
11. If you are in doubt, close
your positions
Individual doubts suggest that there is something wrong with your trading plan. Quickly come out the market if:
- the market behaves irrationally;
- you are not sure in the position;
- you do not know what to do.
Before exposing your money to
risk, you should be exactly sure in what you are doing and that you will be
lucky.
The basis of risk management consists of four steps:
1) Complete understanding of
the risks that the deal is exposed to.
2) The lifting of the risks
that are unnecessary, if it is possible.
3) Be particular over which
risks the deal may be exposed to.
4) Act quickly to reduce the
risk rate, if the market moves against you.
Below we will consider the
example of risk profile and managing your own funds (account), which are
necessary to know by any person, who is wishing to start trading at the world
financial market.
The suggested figures are only
an example of an ideal deal or for a training account at its best. There can
be rather different variations of suggested positions in practice. However, the
planks of the risk profile have to be strictly ensured.
Let's firstly examine such a
question as the amount of primarily deposited funds. The traditional and the
only one answer for the question about the initial sum is «the more the
better». But this answer is probably not suitable as specific guidance for
opening the account.
Usually, the balance between the risk capital assets part
(that part which you can lose) and the invested sum is 1:10. This is a result of the general theory of
west financial markets. It is correct if you can afford it, but basically, in
real cases, this balance is not exactly workable.
The balance 1:5 or 1:3 is used
more often (and more rationally). The more rational recommendation is to take
the sum which you can lose smoothly as a starting point. For example, if you
are ready to take a risk on approximately USD 2000, then the sum of a primarily
opened account can be from USD 6000 to USD 10 000. If you are ready to risk
only by USD 1000, then the amount of an account will fluctuate from USD
3000 to USD 5000 respectively, etc.
As a rule, the leverage 1:100 is offered at Forex
market, the standard lots are presented in the amount of 100 000 US dollars,
euros or pounds. The margin call conditions are fluctuated from 70% of the amount of guarantee for one open position
(if there are several positions, then the sums are combined) to the forced
closure of positions while the amount of guarantee reduces to 3-5% of the
required one. Spreads are usually formed from 3 to 10 points on base currencies
and from 5 to 15 on cross-rates.
All our further calculations and examples we will
speculate from the statement that the volume of primarily deposited funds comes
to not less than USD 5000 and that you are ready to take the risk by approximately
USD 1500. In other words, you did you
first calculations:
- the amount of the account — USD 5000
- the level of maximum losses — USD 1500
Naturally, any changes in balances in favour of risk
capital decline, for example up to USD 1000, can only be welcomed.
The leverage and margin call
level
If you are firmly intended to
abide by your own rules and calculations, then the leverage rate and margin call
will not have such a principal meaning (it means, opening only one position
long before reaching this level). Totally, we can suggest the leverage of 1:100
(standard) and margin call level in the amount of
30% for our approximate account. In other words, if you have one open position
at the account of USD 5000, the floating loss will come to USD 4700, you will
be asked to deposit additional funds. The margin call level will come to USD 300.
The result of the second step of calculations are the following figures:
- the account rate - USD 5000
- the maximum losses level - USD1500
- the leverage rate - 1:100
- the margin call rate - 30% from the actual balance of funds at the account
The cost of a standard lot
point.
The next step consists of one
point value determination of different currencies. Surely, with the change of the currency rate, the value of one point will be variable,
but only changing of the course at least by 300-400 points can be considered as
a significant one.
One point for 100 000 in the Euro and pound contract will cost equally — USD 10, as both these
currencies have a direct quotation against the US dollar and contracts are
usually quoted in the amount of GBP 100 000 and EUR 100 000.
The point cost for
the Swiss franc and the Japanese yen will come to 10 units of the base currency
(id est, the franc or yen respectively), which then should be transferred into
dollars, namely to normalize by the current currency rate.
Thereafter, the cost of one point lot 100 000
dollars against the Swiss franc will cost approximately $6, but against the Yen
will be nearly $8.5. The cost of one cross—rate point is similarly calculated
— 10 points of the base currency, which further transfer into US dollars.
Losses for one position —
average and maximum ones
According to the general
recommendations of control over risks theory, you have to dispense the whole
(maximum) sum of possible losses for your account to three entries at least.
This is the theory. In practice, it will be better to have four-five ones,
or to ten, if it is possible. At this step, you should correlate your trading
system opportunities. So, decide how close, according to the trading system
signal of coming out the position with a loss, will you put the stop—loss.
It is desirable to determine
the amount of maximum possible loss due to one position on such high—yielding
currencies as the Euro and the pound and also the amount of average loss due to
one opening position on less high—priced currencies as the Swiss franc and
the Japanese yen.
Consequently, on the basis of our account — for example, we can
lose at heat $375 on average for one usual position and $500 more for the
highest—yielding currencies. To be more exact, we are able to afford to
lose two times by $330 — 350 and one time - $500.
Considering the definite
currencies it means on an average about 30 — 35 points on the pound,
approximately 40 points on the Japanese yen and nearly 55 points on the Swiss franc.
Assuming the maximum losses on one position, it is 50 points on the Euro and
the British pound, 60 points on the Japanese yen and 80 on the Swiss
franc. Thus, we conclude the third step of our calculations. Now we have:
- the account rate — USD 5000
- the maximum losses level — USD 1500
- the leverage rate — 1:100
- the margin call rate — 30% from the actual balance of funds at the account
- the average level of losses on one position — USD 330 — 350
- the level of maximum losses on one position — USD 500
Profit
According to the theory of risk and capital assets management, the profit
encumbered on one position should be at least 300% of possible losses (the upper limit has no fixed restrictions).
Consequently, from each position, we
have to expect the threefold profit than the possible loss: on average it is
90-100 points on the pound and the Euro and 120 points on the Japanese yen and
150-160 points on the dollar - Swiss franc position.
In fact, having such a small
account it is rather difficult to adhere to proportions, so some flexibility is
permissible: do not encumber the balance less than two to one. For example, the
profit is appointed to be twofold more than the put stop-loss.
However,
according to the risk-to-reward ratio, it is
better not to have experiments. In other words, it is better not to reduce
below the ratio of 1:2. As a result of these calculations, we have:
- the account rate — USD 5000
- the maximum losses level — USD 1500
- the leverage rate — 1:100
- the margin call rate — 30% from the actual balance of funds at the account
- the average level of losses on one position — USD 330-350
- the level of maximum losses on one position — USD 500
- the minimum profit level on one position - from 600 to 700 US dollars
At all these calculations you
have to make a correction on the spread, on commission payment, if the position is
kept for a night, which can be three times more if the payment is for Friday,
Saturday and Sunday.
The main principles according to which all mentioned above
base estimating were done should be
unchanged. However, rather wide variations of main indicators in accordance
with the tactics of your trading are admitted.
For example, to encumber the
profit in the amount of 150 points on the Swiss franc means to keep the position
for two or three days. But if you are an intraday trader, then it is not
suitable for you by any means.
Consequently, the whole amount of losses can be
divided into three sequent unlucky days (so, during the further three days you
will bear maximum possible losses) and then — to average quantities of coming in
for every day.
So, if you are going to open — close approximately 5 positions
during one day, then the loss rate will be $330 — 350 per day, the losses on
one position will be nearly $65 — 70.
But do not forget about the profit, it
should be not less than USD120 — 140. Or, for example, if you use different
tactics of trading — intraday, medium-term (one, two days) or long—term
ones (on the week), then allowed losses on each definite operation type, keeping
one—third of the whole losses sum to each activity category, then — as
appropriate. You can, for example, keep one week for intraday trading and count
on three-five coming in per day.
At the medium-term trading —
also one week, but only three coming in etc. or add some extra rules of self —
check: if during a week your account reduces three from five working days, then
you will have to stop and think over where the mistake was made by you, even
before the margin call or reaching the maximum losses level.
There are a lot of
variations. Here is like in the cookery: the recipe is one for everybody, but
every person cooks in his/her own way. The main thing is not to recede from the
general ingredients. The principles of risk profile and capital assets managing
are the most important ones in any financial market work.
As we said it the
main purpose is not only to get profit but not to lose more than it was suggested.
So only you can provide the safety of your capital assets and won a sum of money.
Otherwise, even luck will not help you: if you can not
restrict the losses, then some sequent profit deals will turn to be a regular
loss of almost all your funds in the result.
Unfortunately, wrongly or due
to the lack of experience requirement, these principles usually are not paid
attention to. The major traders are still considering that the main thing is to
guess where the market is going to move.
If you guess it will be good for you,
but if you do not, then you can try to wait for, maybe the market nevertheless
will move to the right side? Unfortunately, you have not to hope on the off chance
in a real life. The main part of a trader's work is not to admit the worst.
Naturally, that you have to care for these and other troubles in advance. And if
the market moves against you (this will take place very often), then you will
be more peaceful to
know that the worst thing you have previously provided.
The plan of managing your
capital assets will bring you the profit only then when you do what it dictated
you to do. This means, that it is necessary not only to carefully plan your
deals, as written above but to trade according to this plan. if you reach the
stop-loss price, then you have to admit this stop.
If you found out that your
trading system steadily gave you stops, which worked, then possibly you had to
overview the system rules. Another way you will be forced to absorb a bigger risk
then it was planned, enhancing the chances that a bad trading system will lead
you to collapse.
Accept the losses when they are small, otherwise, they will
become big. Here the great significance has the discipline. It is worse if the
market will turn and make the deal profitable, as now you are psychologically
ready to make new mistakes.
Quickly come out and overestimate the situation. If
you suggest that it can turn, then open a new deal with a new stop. The faith,
hope and prayers leave for God, indeed markets are false and unsteady idols.
Lessons: