Advanced Risk Management

ADVANCED RISK MANAGEMENT 

Risk management is one of the most important topics you will ever read about trading, it is essentially a set of rules that are designed to minimize your losses and maintain a reasonable risk/reward ratio when placing trades.

KEY ELEMENTS OF RISK MANAGEMENT

• Risk to Reward Ratio (RRR)
• Stop Loss
• Take Profit

Risk to Reward Ratio in forex trading refers to the relationship between the potential profit of a trade (reward) and potential loss (risk).

It is expressed as a ratio, such as 1:2, 1:3, etc. (1 stands for risk, 2 and 3 stands for reward) indicating that for every unit of risk, there is a potential reward of two or three units, respectively. Traders often aim for a favorable risk-to-reward ratio to ensure that potential profits outweigh potential losses overtime.

A trader doesn’t just select a RRR but the selection will depend on the trading style.

In forex trading, it’s essential for a trader to determine whether they will risk their capital consistently in terms of a percentage or money.

Example

A trader with 500 USD capital buys the EURUSD currency pair and decide to risk only 50 USD with a RRR of 1:2

Capital: $500

Currency pair: EURUSD

RRR: 1:2

Risk: $50

Reward: $100

Take profit is the specific price level set by a trader at which a position will automatically be closed to secure the anticipated profit.

Stop loss is a predetermined price level set by a trader at which a losing position will automatically be closed to limit the potential loss.

Setting a take profit and stop loss will depend on the number of pips one is willing to risk and the size of the position.

Example 

A trader with $1000 capital aims to risk 10%, which is $100, with RRR of 1:2. To achieve this, they intend to use a position size of 0.1 targeting 100 pips to stay within $100 risk.

SO,

Capital: $1000

Risk percentage: 10%

RRR: 1:2

Risk amount: $100

Reward amount: $200

Position size: 0.1 lot size

Risk per pip: $1 (since 0.1 lots represent 10,000 units of currency and each pip movement is worth$1)

To limit the risk to $100, the trader needs to ensure that the stop loss is set at a level where a movement of 100 pips would result in a loss of $100. On the other hand a reward of $200 will result into a movement of 200pips.

RISK MANAGEMENT BASED ON TRADING INSTRUMENTS

Trading instrument are financial assets that traders buy or sell on the foreign exchange market. 

They include

• Currency (Major and Exotic)
• Metals (example Gold)
• Indices (example Nasdaq100)

• CURRENCY PAIRS

As a trader, you need to be aware of the varying power of currency pairs. For instance, a standard lot of 1 typically values 1 pip at $10, this valuation varies across major pairs. Thus, it is important to understand these differences to assess the amount you are willing to risk accurately.

Example

In different currency pairs, we observe varying pip values. To mitigate risk effectively, it's essential to be aware of the pip value associated with each pair. For instance, the pip value for standard lot size of 1 for USD/CAD is 7.3, while for GBP/CHF, is 11, representing a difference of 3.7. 

• METALS

These are precious metals that are traded against currencies. The most commonly traded metals are gold (XAU), Silver (XAG) and platinum. Metals can be traded against major currencies like US dollar, offering traders diverse opportunities in the forex market.

FACTORS TO CONSIDER WHEN MANAGING RISK TO GOLD TRADING

• Contract Size
•  Pips
• Capital

Contract Size

Brokers offer different contract size depending on the trading instrument. While some may provide smaller sizes like 1 to 10, the standard size typically stands at 100, representing more power. In some cases, brokers may offer even larger sizes, like 500 which is very powerful and difficult to apply risk management for retail trades. As the contract size increases, so does the difficulty in implementing the risk management strategy.

Pips

When trading metals, the number of pips to risk is determined by the trading style, such as for scalpers who are short-term traders. Due to the short distance of pips in metals at lower time frame, scalpers typically risk very few pips, like 10. This minimal risk is feasible because covering 10 pips in metals usually takes only few second to minutes.

Capital

When considering capital in metal trading, it's crucial to align it with the chosen trading style. Scalpers, for instance, may allocate smaller amounts of capital per trade due to their rapid turnover. Since scalping involves quick trades with minimal risk, traders may opt for a smaller portion of their overall capital per trade, ensuring they can sustain multiple positions throughout the trading session. Conversely, traders employing longer-term strategies may allocate larger portions of their capital per trade, reflecting their willingness to withstand greater fluctuations in the market. Ultimately, the allocation of capital should be tailored to the trader's risk tolerance, trading goals, and chosen strategy.