September 07, 2017
Without risk management, even the best trading strategy in the world will fail in the long run. Most traders rush into trading without thinking about risk management, and that is the number one reason why many of them fail. The fact is, risk management is the most important part when it comes to be a successful trader. It defines your risk per trade, lot size, when to cut losses or take partial profits, etc. It’s what makes the difference to the bottom line between a profitable and losing trader.
How Much Capital do I Need for Trading?
The amount of initial capital that you need for trading depends on various factors. Beside the initial trading capital, some traders also decide to invest in other trading tools with the hope to get an advantage in trading. For example, you could join a trading course which can cost anything between a few hundred to a few thousand dollars, or you could simply learn on your own with websites that teach you how to trade.
Additional charting software, special indicators or a live news feed for fundamental data can also cost a lot of money. You really need to ask yourself if this will help you in trading and if it will pay off in the long run.
And then we come to the trading capital. To trade on the forex market, you’ll need to deposit your initial trading capital with a broker. The amount will vary from trader to trader, and some brokers even accept initial deposits as low as $20. Of course, trading with an account this small is not a good idea, as you’ll need enough capital to withstand price fluctuations and to set reasonable stop-losses.
The size of your initial capital depends on how much you can afford to invest, and you should only trade with a sum that you’re able to lose. Don’t trade with all your savings! That being said, anything of $1,000 and above will be enough for the start. However, don’t expect to earn for a living with a trading account of $1,000. Once you feel confident with your trading strategy, you can invest more as it will allow you to increase your position size while respecting your risk management. In fact, some traders deposit $100,000 in their trading account, or even more!
Drawdown and Maximum Drawdown
If you don’t follow a strict risk management, you could quickly experience a drawdown in your account, or even blow your entire trading account. A drawdown is simply the reduction of your trading account after a series of losses, presented in percentage terms. For example, if your trading account went down from $10,000 to $5,000 after some losing trades, your drawdown would be equal to 50%. Your maximum drawdown is calculated in a similar way, and represents the maximum loss of your account from its peak to its lowest trough, before a new peak is attained.
How Much Should You Risk per Trade? The Golden 2% Rule
How much of your trading account should you risk on a single trade? The golden rule is to never risk more than 2%. If you’re new to trading, the risk per trade should be even lower, at around 1% of your trading account.
If the size of your trading account is $10,000, you should never risk more than $200 ($10,000 x 0.02) on a single trade! This way, you’ll still have enough capital if you experience a series of losing trades.
The reward-to-risk ratio measures how much you risk on a trade to how large your potential profit will be. Ideally, you would like to take trades with a reward-to-risk ratio of at least 3:1 or larger. This means, you have the potential to gain 3 times more than you’re risking. For example, if your stop-loss is 30 pips, you should aim to a profit of 90 pips to maintain a reward-to-risk ratio of 3:1.
This also depends on your trading style. If you’re a scalper, you could go for a lower reward-to-risk ratio, while position traders can aim for a profit that is 10 times the amount they’re risking (a 10:1 reward-to-risk ratio.)
Risk management is the key concept to survive in the forex market. It makes the difference between profitable traders and losing ones. Your risk management plan should strictly state what your stop-loss levels and risk per trade are, what trades you will take based on your reward-to-risk ratio, and what position sizes you will trade. Even the best trading strategy in the world will eventually fail if you don’t pay attention to risk management and know how to cut your losses.