What do we mean by Risk Management?
Risk management is the part of the trading strategy that deals with how much risk are we willing to take. If we were at a casino that would be our bet.
When trading the Forex markets, We spot about four different issues related to risk management. The first one is the pip risk, or how much money per pip are we risking. The second one is the positional pip risk, how far, how many pips, is the entry to our invalidation point. The third being how far is our profit taking level, and the fourth one is how much total risk and how this amount is related to the expected reward.
We all know that the Forex market uses leveraged trading instruments. Everyone here should know that leverage is the proportion between the real value the open lots or contracts and the trader’s account size. We can also say that it’s between the real value of a lot and the margin the broker is demanding to open it.
In any case, the size of the lot defines the risk per pip movement. We know that on all pairs but the ones involving the Yen, the pip value is the 4th decimal place. Therefore the risk per lot and pip is 10 units od the quote currency ( the right side of the pair). So, a trader on the EURUSD risks 10 dollars per traded lot, and, so, 1 dollar per mini lot and pip.
Positional Pip Risk
We define Positional Pip Risk, as the total pip difference between a possible entry level and the level at which the trader consider the trade movement invalidated, closing there the trade. Let’s consider chart 1 a potential short trade on the USDJPY pair.
We have set our sell entry just below the recent lows, at 111.885 and our invalidation level was set slightly above the red key resistance level, at 112.320. If we position the cursor on the red and green rectangle showing the trade plan we can see that this corresponds to 43.5 pips.
Potential Pip Profit
Conversely, the potential pip profit is the distance between the entry point and the profit target, or what MT4 calls take profit level.
On this case, the target was set at 11.263, so the potential pip profit is 62.3 pips.
The Reward factor
I call the reward factor a multiplier factor which when applied to the positional pip risk value results in the potential pip profit figure.
The reward factor tells us the reward multiplier for the risk. There are plenty of reasons why a trader might want to know this figure. Suffice to say that if we want to be successful, we need to look at the trading activity as a business. And, businesses want to make sound decisions. A sound decision is the one whose potential profit is higher than its potential reward.
In the trading business, this has another side to it, filtering out poor reward-factor trades we make sure that our trading strategy or system is able to withstand a period of reduced per cent of winners. That is so because with high reward factors we don’t need to be right too often to reach the break-even point. As an example, let’s consider that Jane the Trader has a system with a reward factor of 2, while Phil the wannabe trader has a reward factor of 0.5 and let’s find out the winning percentage both will need to be in the green side.
Jane knows that if, on average, she has more one winner every three trades, or 33.3% winning rate she will be profitable. Phil surely doesn’t know that he will need to be right two out three trades to just break-even. Which trader would you put your money on?
The dollar risk
So far, we haven’t talked about the dollar risk, but only about the pip risk. Therefore, it’s time to round the circle and talk about that. The dollar risk is what matters in reality but we needed to make pip risk and reward clear before going into this topic.
Dollar risk is linked to several concepts. One is position size, the other is the trader’s account balance, and the third is the drawdown and the risk of ruin.
Computing the dollar risk is simple: We multiply the positional pip risk by the number of contracts traded. Therefore we need to know first how many contracts is the trader going to open. If we want to trade as a business, this shouldn’t be a lightly-taken decision. It should be an important part of the overall trading strategy.
Thus, how to properly and rationally set the position size?
Well, this is the subject of the next article, Position Size, Risk and Returns