forex risk management traders ruin

Forex Risk Management : Are You Suffering From “Trader’s Ruin”?

Forex risk management is not exactly a sexy topic!

Most traders just aren’t that bothered by it.

Write an article on a huge winning trade, the latest “hot” trading system, or a magical trading robot, and people will go crazy over it.

Put out an article on how to manage risk in forex trading and you get…crickets.

But look…it’s understandable.

It’s easy to get people excited about big wins. It’s easy to provoke dreams about wealth, freedom, fast cars and big houses. The dreaming is entertainment in itself. That’s why millions of people queue up to play the lottery every week. Even though, statistically, it’s one of the worst bets you can make.

On the other hand, you can’t expect people to get excited about preserving what they already have. (This runs contrary to the argument posed by a certain Nobel Prize winner, but I’m happy to argue that forex traders are something of an anomaly).

In forex trading, the lure of the big win will always trump the humdrum hanging on to what you already have.

But that’s ok.

As a website that aims to provide realistic information to traders, we make no apologies for focusing on risk management in the forex markets.

We think that the lack of focus and education in this area is one of the main reasons why forex traders fail, so we’re going to play our part in correcting that.

If that means crickets, then so be it.

Why the lack of information?

If risk management is so important, why does the online forex trading community not focus on it more?

The answer is simple supply and demand.

If readers aren’t that interested in a topic, websites won’t write about it.

If traders are most likely to click on information about a magical, secret, wads-of-cash expert advisor, that’s the information websites will feed them.

Risk Management in Forex Trading and “Trader’s Ruin”

So here are four of the most important risk management highlights that we’ve been looking at over the last few weeks:

1. How your risk management strategy is just as important as your trading strategy

First, let’s get a couple of things straight.

If your trading has a negative edge or expectancy, no amount of fancy risk management will help you. Risk management can’t turn a negative edge into a positive one (we talk about how you can get a trading edge in the PAST Video Course).

But, if you don’t manage risk properly, you can lose money even if you do have a trading strategy with an edge.

This is where Gambler’s Ruin comes in.

 

In this video, I take Gambler’s Ruin and suggest that it could just as easily apply to traders, i.e. “Trader’s Ruin”. You can decide whether you agree with me on that or not. But the theory behind it is this:

A persistent gambler (or trader) who raises his bet to a fixed fraction of bankroll when he wins, but does not reduce it when he loses, will eventually and inevitably go broke, even if he has a positive expected value on each bet.

This is a concept that’s central to risk management in forex trading.

You simply have to reduce your position size when you lose trades.

If you don’t, it doesn’t matter how much of an edge you have, or how great your trading strategy is, you’re going to run into big trouble.

At some point, the market is going to squeeze you. It always does. It’s going to test your mettle.

Reducing your position size during a period of losses gives you some extra breathing room. It gives you a cushion, a reserve which you can dip into when the market has singled you out for special attention.

In trading, there are times to attack and times to defend. If you are increasing your position size while facing a market that is putting you under pressure, that battle is only ever going to have one winner.

And it’s not you.

2. Botching up an world class trading strategy with poor risk management is the easiest thing in the world to do

To examine this theory, we looked at this study. It examined the risk management behaviour of finance professionals and graduates who were asked to take this test.

It provided them with a strategy that had an edge. The strategy was depicted by a rigged coin that had a 60% chance of landing on heads. They were told about this edge in advance.

study_2-min

The study found that a significant portion of finance professionals and graduates (28%), even when handed this profitable strategy, still managed to go bankrupt.

Resist the temptation to mock these people.

That 28% of the participants, who busted their accounts, did so due to biases and cognitive distortions that affect us all. It’s incredibly easy to lose control of risk and position sizing, even if you have a great trading strategy.

Don’t fall into the same trap.

The lesson here is this: next time you find yourself struggling in your trading, don’t automatically assume your strategy is to blame. It could be that your trading risk management strategy needs to be assessed instead.

3. During streaks, superior forex risk management can increase your gains and reduce your losses

Forex trading is a game of small margins. It’s ferociously competitive. There’s often a very fine line between profit and loss. In this environment, we need to be efficient and cling onto any advantage we can get, no matter how tiny it is.

If your trading results show streaks (i.e. multiple winning/losing trades in a row) risk management and position sizing becomes even more important. Because if you experience streaks, risking a fixed % of account equity per trade (the risk management strategy we recommend) can actually have the effect of making your winning streaks more profitable and your losing streaks inflicting less damage.

Granted, the effect is not huge, but depending on the length of the streak you go on and the amount you are risking per trade, it can be meaningful.

Don’t fall into the trap of thinking that a couple of percent points is nothing.

In a competitive business, a tiny edge can be all the difference. Because even if that tiny edge is all that you have going for you, as long as you maintain it you can exploit it.

Those tiny edges can be turned into huge profits over time.

4. Managing risk just like the professionals is easy

There are many ways to manage risk in the markets.

If you are risk manager in a big bank, you probably have models and excel workbooks so complicated they would cause the average person’s brain to short-circuit.

At the other end of the spectrum, you have traders who don’t practice any risk management strategy whatsoever.

We think that there is a balance to be struck.

risk 1 per cent forex trade trading quote

You can adopt a risk management strategy that takes minimal effort to use, but delivers 99% of the advantages.

And that is the same risk management strategy as Larry Hite, a successful fund manager and one of Jack Schwager’s Market Wizards.

Risk 1% of your account equity per trade.

Really simple, and easy to implement. And it will keep you out of trouble, save you from Trader’s Ruin, and help you take full advantage of any hot streaks you happen to embark on in your trading.

The easiest way to trade like this is to use the Forex Useful MT4 Risk Manager.

Are you a Gambler, a Bettor, or a Speculator?

  • Most retail forex traders are gamblers

They trade with little appreciation of the importance of an edge. They are trading to be entertained, to be excited, to get a quick thrill of making some money.

Their inevitable bust accounts are simply the price they pay for that entertainment.

  • Some retail forex traders are bettors

Bettors also have little appreciation of the importance of an edge. Their main focus is being right, and avoiding being wrong. They derive their value from their supposed ability to predict the market. They take great pride in being able to “call” market moves in advance.

Some forex market analysts would fall into this category too – where they might spend much of their time trying to predict what is going to happen next, but might not even risk any money on that view whatsoever.

  • Finally, a very small portion of retail forex traders are speculators

Speculators, first and foremost, appreciate the importance of having an edge in the market.

They have no emotional attachment to being right or wrong. They understand that they can’t control or predict day to day events. But they know that over the long term, they can develop an edge and exploit it for profit.

Speculators are the risk managers. They understand that capital preservation is vital. They understand the need to limit losses when they’re wrong and get aggressive and greedy when they’re right.

They are laser-focused on making money.

Take the example of a trading strategy that has 95% of its trades are losers. 5% of its trades are winners. Average winning trade is 200 pips, average losing trade is 10 pips (I’m assuming pip sizes are equal for simplicity).

On the face of it, it’s a profitable strategy – it has an edge.

What will our gamblers, bettors and speculators think of it?

  • The gambler won’t be interested - too much like hard work and not enough excitement
  • The bettor also won’t be interested - too many losses, very hard on the ego!
  • The speculator? Of course, he'll be all over it. Massive profit potential. He doesn’t care of the make-up of the trades, just that they are profitable. He’ll roll up his sleeves, he’ll get to work, and he’ll make those profits.

Decide what you’re in the market for, act accordingly, and above all, manage your risk.

If you have any questions or comments, leave them below and I’ll get back to you.

 

 

All the best,

Nigel

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DISCLAIMER & COPYRIGHT

This update is based on my analysis on my charting package. It may differ to yours as it can be affected by time, market movements, charting packages and broker prices. I accept no liability for loss or damage, including without limitation to, any loss of profit, which may arise directly or indirectly from use of or reliance on any information in this report or analysis.