Risk managment: Why to risk only <2%?

[lancelee]

if you risk a lower fraction of your account per trade, you give yourself a better chance of weathering a short term losing streak that reduces your account balance

i have a related question on this topic. in risk/money management, if i should risk at most 2% of my capital with each trade, should i calculate my position size this way?

1. assuming i have $2,000 risk capital to risk, and i’m prepared to risk 2% of my capital, i.e. that equates to a max. of $40 loss on each trade.

2）for each trade that i enter, say i make it a point to have a stop loss of 50 pips (as an example)

3. do i calculate such that each pip loss = $0.80 , and i take a lot size respective to that?

the reason why i’m asking is because i’m very new to trading, and I’m still working out the details. To speed up my learning curve, i subscribed to a trade copier program where my account copies the same trades as the master account of a very knowledgeable author of my favorite books on forex trading.

looking at the trades that are copied (which mirrors the same risks ratio) each trade is placed at 0.02, which i assumed means 2% of my capital, which is not the same as risking 2% of my capital?
because looking at the losses and gains so far, the maximum loss i saw was only $8.50, which is less than a quarter of my 2% risk ($40)

should i increase my buy/sell from 0.02 to 0.08 in this case? given the stop losses of 50 pips in place?

[ropunzel]

3. do i calculate such that each pip loss = $0.80 , and i take a lot size respective to that?

Yes that is pretty much right. If you are working with $2,000 and want to risk 2% which is $40. You need to then work out the number of lots that give you that risk within 50 pips.

The general formula is:

Lotsize = Risk/(PnL1Pip1Lot x SLDistance x point)

SLDistance = Stop loss distance, in this case 0.0050
Risk = $40
point = point value (decimals) on MTA this value is given by 0.1/Point = 10,000
PnL1Pip1Lot = Profit and loss for 1 Lot moving 1 Pip

[Jason_Rogers]

@LaughingCharlie

It relates to the availability of what you want to buy, at the price you want to pay for it.

The more you want to buy, the more the prices increases.

When you have a £1,000 account you can fairly reliably trade anything you want, in whatever size you want, at the price showing on your screen. When you have a £1,000,000 account, you can’t.

That’s a good point. There’s a limited amount of a liquidity available at each price. The larger the order size placed, the likelier you may be to consume all liquidity and experience slippage. Plus you’re not the only trader that may be trying to capture liquidity at the quoted price.

Our positive/negative slippage stats from 1 January 2018 to 28 February 2018 highlight this. Look at what happens to slippage as the order size increases.

Traders trading larger sizes may be better off scaling into positions to prevent this from happening.

Consider how a liquidity provider is pricing, whether it be a broker acting as the market maker or straight through processing by an external liquidity provider. There is often a trade-off between how tight a spread is being offered and the amount of liquidity available at that price. Offering a 0.1 pip spread can be risky because it gives less room for the liquidity provider to manage orders being executed. If you’re wrong, it’s better to be wrong on a small amount (offering less liquidity at that price). Offering a 1 pip spread can be less risky because it gives more room for the liquidity provider to manage orders being executed. You can be more generous with the amount offered at the price.

Jason

*Past performance is not indicative of future results
Trading forex/CFD’s on margin carries a high level of risk and may not be suitable for all investors as you could sustain losses in excess of deposits

[ontario]

Great explanation Jason, thanks. What about a broker which offers ECN execution and aggregated liquidity? Can such broker offer better spreads comparing to STP one since they can divert the amount of orders received from the traders to different LPs? Or am I mistaken?

[Jason_Rogers]

Hi Ontario,

That’s a very good question. The trade-off between spreads and liquidity would still exist on an ECN. And when I say ECN I’m referring to trading venues where you might expect larger players such as hedge funds and HFTs to trade such as the CME, EBS, Reuters, FastMatch, etc. It’s almost more dangerous to offer generous liquidity on tight spreads at the ECN level because of the sophistication of participants such as High Frequency Traders (HFTs). HFTs are typically in and out of trades in milliseconds and run algo strategies to automate their trading. As before, if you’re wrong, it’s better to be wrong on a small amount because mistakes will be taken advantage of very quickly by HFTs and other sophisticated participants. (A topic that could go on even more. Read Flash Boys if you want to learn more about HFTs and background on what can happen with liquidity)

Compare the trading style of an HFT to that of a retail traders. Even the fastest retail traders are likely to hold trades open for a few seconds or more. The longer trading time frame makes it possible for liquidity providers to be more flexible with their pricing.

To further compare ECN vs. retail trading… FXCM did a study in 2016 that compared the price at which actual trades were executed at with FXCM compared to the quoted price at that exact same time on the futures market and the interbank market to see which venue had the better price. The study is based on the trade data of FXCM LTD clients on NDD (STP) forex execution of over 40 million orders from October 1, 2014 through March 31, 2106. The study found that orders executed through FXCM were equal to or better than the futures price 81% of the time and equal to or better than the interbank price 94% of the time. And that compares the actual order execution at FXCM which includes any slippage, with the quoted price at the futures or interbank level not taking into account potential slippage. The full study can be found here fxcm_ltd_execution_study.pdf (1.9 MB)

So just because you may be able to trade on an ECN doesn’t necessarily mean you are going to get better pricing.

Back to order management… If you plan on trading large amounts of volume, say over 500k to 1M per click, then consider breaking up your order. If the broker you are trading with offers depth of market (available at some STP brokers), review the amount of liquidity typically available at the top of book. Keep in mind volatile periods such as news events may attract a larger number of orders from other traders as well, so you’re not the only one competing for that top of book liquidity. If you’re trading with a dealing desk broker, ask the broker what amount of liquidity they typically have on offer at the quoted price and what maximum order size they suggest per order. Their main concern is being able to effectively manage the risk on that trade and offset it internally or with their own liquidity providers.

As for FXCM, we run a hybrid dealing desk/no dealing desk model. The best available bid/ask is aggregated from multiple liquidity providers to automatically determine the spread, and our trading desk may execute trades internally or offset with a liquidity provider based on certain risk parameters. The advantage is that it gives us the ability to offer execution with no restrictions and accept trading strategies such as scalping, while effectively managing the risk.

Sorry for the long answer . Have a great weekend.

Jason

*Past performance is not indicative of future results. The study does not in any way attempt to represent that FXCM maintains a particular capacity or performance level. The figures in this study are provided for information purposes only, and are not intended for trading purposes or advice.

Trading forex/CFD’s on margin carries a high level of risk and may not be suitable for all investors as you could sustain losses in excess of deposits

[ontario]

Thanks for perfect explanation, now Il will definitively set my choice on ECN trading venues

[Falstaff]

I honestly don’t understand why it is advised in so many places to risk only 1-2% of your capital when placing a trade. Speaking from the mathematical perspective it’s simply not an optimal thing to do. For example babypips school’s risk management article compares risking 2% vs 10% per trade. So it goes something like this:

A forex trader has 20k in his account. From the day one (which is highly unlikely in the real world) he starts to lose money, presumably due to bad market conditions, not because his strategy sucks. So after some time this trader experiences the total equivalent loss of a 20 trades losing streak, which draws his account down to $13350 (2% risk) or to $2430 (10% risk).
Now let’s say the market conditions changes and he finally starts to make money. And the amount he have made is a equivalent to a 30 trades wining streak. So how much does this guy have now? $24180 when risking 2% and a whooping $42400 with 10% risk! waat!?

Does that mean the more I risk the more I make or is my math broken? Even risking a ridiculous 30% per trade would not have killed it. The dude would still have $42k in his account at the end. ($20k -> 16 bucks -> 42k)

I think the OP had a valid point here and I have argued it previously (16 years ago perhaps) on a forum called “Tactical trader” Why on earth woukd you put 100,000 in an account and only risk 1-2% ?

I think the probem is coming from a misunderstanding of what the “Big Boys” do - ie the pension funds etc. - They may well only risk a miniscule persentage at any one time in “Trading” whether that be Forex, Shares etc etc and to them a drawdown of 5% in a year would be a massive disincentive for future investors to trust them with their money.

The question which is NOT addressed by the 2% slaves, is wtf is the OTHER 95% ?

Now I am not “privy” to that information, but what I do know is that by and large the “Big Boyz” underperform a simple tracker fund.

I expect a large portion of thet 95% will be invested in Property acquisitions and “Leaseback” arrangement, Govt Bonds, etc and it used to be the case that “deposit accounts” actually paid a strange thing called “Interest” so they would have any oddments invested in these places.

We are different.

STick £100,000 in a “Broker account” at zero interest and risk only 1-2% at any one tme and you could easily be accused of Incompetence !

My point being that if you have £100,000 to “Play with” - your £100,000 at 1% becomes £1,000 for each trade. So now you perhaps buy a rental property on mortgage with a deposit of £80,000 and an annual income of £9000 against which you perhaps have a mortgage and “ancilliary” cost of say £7000 - PLus you have the massive potential for Capital Growh. The value of your trading account becomes perhaps £20,000 and your £1000 “Risk” now becomes 5% - the cash value of which decreases with each loss and increases with each win.

So why on earth would anyone bet only 1% of their "Account balance " ?

[artawidi]

Lets assume u have trading system with 1:1 RISK with 70% change to win,
U can open multiorder with different pair but each trade u risking 1%,
Says u open 10 order and 4 become loss , u still get 6%,

Now lets say u order 1 position with risking 10% capital,if u get win thats great
But if u loss ,now ur capital become 90%,

To get ur capital restored to beginning u need ur system to win with 1: 1.2 risk to reward ratio, which is harder to win

[anon76360754]

Well good for you, hope you have $100k to cough up so that you can open a ‘true’ ECN account

[ontario]

No only 3K to trade with HF and Tickmill I split between them in 2:1 ratio, one account is for high risk trading on news, second is for fundamental trading.

[anon76360754]

That’s not a ECN (DMA) account though, is it. It’s a NDD retail account.

[ontario]

How do you tell apart ECN from NDD STP? Brokers don’t share this kind of information, there should be some indirect observations that help you to make conclusion.

[anon76360754]

They really do share this information though, perhaps one of the most popular retail DMA brokers being “Interactive Brokers” (IB).

In today’s retail environment ECN, STP and NDD are one of the same with little noticeable difference.

Take a look at IB, there website explains a lot and they have a great education section, even if at first sight it makes little sense.

[ontario]

They claim, not share sensitive information. Go and ask what’s their liquidity providers they won’t reveal. that’s the difference between knowing what’s exactly under the hood and believing what’s inside

[anon76360754]

I think this more about not knowing what DMA consist off whilst living in the retail fallacy of assuming that everyone is out to get you?

[FOREX.com]

So why on earth would anyone bet only 1% of their "Account balance " ?

Hi @Falstaff,

Keep in mind this 1% guideline is for a single trade not the lifetime of your forex account. Depending on your trade frequency and duration, you might place several trades in a single month, week or day, and also have multiple trades open at the same time.

Your goal should be to have a risk management approach that stands the test of time, and if you trade long enough you will encounter losing streaks. When that happens, drawdowns to your account balance can add up quickly if you risk more than 1% per trade.

You may find this article helpful in understanding the rationale behind risking only 1% per trade: The Most Important Math in Trading | New Trader U

[krugman25]

As Warren Buffet once said, any number times zero equals zero. In essence, what good is making crazy gains by taking huge risk when only 1 or a few trades will wipe them all out. In real life if you trade long enough you will lose 5-10 trades in a row or more, no matter how talented you are. The only way to survive a string of losses is to keep risk per trade low. IMO 2% is on the high end. The stars would have to align for me to take a risk even that large.

Keep your risk small and let compound interest work for you, far less risky and more lucrative.

[FOREX.com]

As Warren Buffet once said, any number times zero equals zero. In essence, what good is making crazy gains by taking huge risk when only 1 or a few trades will wipe them all out. In real life if you trade long enough you will lose 5-10 trades in a row or more, no matter how talented you are. The only way to survive a string of losses is to keep risk per trade low. IMO 2% is on the high end. The stars would have to align for me to take a risk even that large.

Keep your risk small and let compound interest work for you, far less risky and more lucrative.

Quite right, @krugman25!

There are no shortcuts to long term success.

[Falstaff]

As Warren Buffet once said, any number times zero equals zero.

He may have said that, but it was certainly Albert Einstein who said “Compound Interest is the eighth wonder of the world !”

What rate of interest do you actually get on the deposit in your broker account ?

Keep your risk small

I’m not convinced we are fundamentally disagreeing here,

Let’s say you have £100,000 in your broker account and therefore your “Risk” is £1,000 per trade. - You are comfortable with that level of risk, have a decent income and “working capital” of the same £100,000 dedicated to your trading endeavours.

Now lets also assume you have a modest mortgage of £85,000 which is one of those mortgages where your wages get paid in and you pay interest (Say 5% pa) on the outstanding balance. You can pay your bills and expenses by drawing against your property value - A very efficient instrument.

Now we know that your appetite for risk on your trades is £1,000 each - SO why keep the whole £100,000 sitting unused in your “Broker account” - why not pay £80,000 into your mortgage account, Saving yourself £4,000 in the first year, and continue to trade the £1,000 per trade - knowing full well that if you have a major drawdown, you can add funds to your broker account, from your reserve fund which is currently working away generating “Compound Interest Savings” in your mortgage, to enable you to continue in accordance with your original intentions ?

[krugman25]

As Warren Buffet once said, any number times zero equals zero.

He may have said that, but it was certainly Albert Einstein who said “Compound Interest is the eighth wonder of the world !”

What rate of interest do you actually get on the deposit in your broker account ?

Also a great quote. Yet compound interest isn’t an excuse to over-risk.

krugman25:
Keep your risk small

I’m not convinced we are fundamentally disagreeing here,

Let’s say you have $100,000 in your broker account and therefore your “Risk” is $1,000 per trade. - You are comfortable with that level of risk, have a decent income and “working capital” of the same $100,000 dedicated to your trading endeavours.

Now lets also assume you have a modest mortgage of $85,000 which is one of those mortgages where your wages get paid in and you pay interest (Say 5% pa) on the outstanding balance. You can pay your bills and expenses by drawing against your property value - A very efficient instrument.

Now we know that your appetite for risk on your trades is $1,000 each - SO why keep the whole $100,000 sitting unused in your “Broker account” - why not pay $80,000 into your mortgage account, Saving yourself $4,000 in the first year, and continue to trade the $1,000 per trade - knowing full well that if you have a major drawdown, you can add funds to your broker account, to enable you to continue in accordance with your original intentions ?

I think your confusing risk and leverage. Risking 1% on a trade doesn’t necessarily mean you are only using 1% of capital. A 1% risk trade may require multiple lots and tie up 10-20% or more of your capital. Leverage is about capital efficiency and risk is about capital risk and longevity.

This is the first time I’ve ever seen house mortgage rates used in a risk-per-trade discussion. There is a first time for everything, haha.