Risk managment: Why to risk only <2%?

Trading Discussion
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Experienced traders are the ones who understand that successful trading is all about risk-management, not profit-maximisation, Mom: the ones who don’t learn that typically get filtered out of the trading process before really becoming “experienced”.

Pro-traders wouldn’t dream of risking a drawdown bigger than about 5% of their accounts, and that would be only during an extreme, unusual bad run.

[I][U]Key concept[/U][/I]: one of the major problems with subtantial drawdowns is that if they arise, it becomes extremely difficult to judge whether the system is “just having an unusually bad run” or “has stopped working”, which predicates that one couldn’t even decide confidently, under those circumstances, whether or not to continue: exactly the type of situation the planning, design and position-size-modeling process should be designed to avoid.

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You could have been talking about me, there :slight_smile:

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Good point, I didn’t consider the possible for a strategy to stop working for real. It does make sense now. i probably will grow more conservative with time, but you know when there is only 10k to trade with, you don’t really have a choice, but to risk more to make trading worthwhile. Yea it’s the classical reason why traders fail - undercapitalization.

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Trader failure due to under-capitalization relates to being forced to trade too large relative to your account (you could call that excess leverage). Given that it’s very easy in retail forex to trade small positions, that really shouldn’t be an issue from a mechanical perspective.

What that leaves is the “worthwhile” aspect you bring up. That’s either “It’s not worth my time,” or “I’m not gaining a sufficient psychological reward.” The former is always a potentially consideration for low-cap traders. That’s a rational subject. The latter case is more problematic. It’s about not being satisfied with performing well from a process perspective - meaning focusing on making good trades and achieving good returns in percent terms as opposed to dollar terms.

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Sorry, Mom, yet again we disagree: I see at least two other options …

(i) Go more slowly: the overwhelming majority of aspiring traders hugely overestimate what they can achieve quickly, while equally strongly underestimating the future returns from what they could achieve gradually, if they only avoided blowing their account with excessive position-sizing;

(ii) Research, develop and use methods which involve more frequent trading, so that the returns from small position-sizes can safely be compounded more quickly.

I think actually undercapitalization is probably the [I]rarest[/I] (relatively speaking) of the “five common reasons” for aspiring trader failure. Most of the people who attribute their failure to undercapitalization, in my opinion, if they’d had greater trading capital, would actually have lost that as well.

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In forex, I’d agree. Other markets it’s a bigger issue.

Most of the people who attribute their failure to undercapitalization, in my opinion, if they’d had greater trading capital, would actually have lost that as well.

Interestingly, I found that among the retail forex traders I studied in my PhD research, there was a strong negative correlation between account size and leverage use. Obviously, that doesn’t mean those folks with larger accounts aren’t making the same stupid mistakes smaller accounts make. It just means those mistakes cost them less relative to their capital.

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Hey everyone going off topic but would you only still risk 1% per trade if you had £1,000,000 account, on my system I have 1:3 ratio so at moment with my £1000 live account I make about £20-£30 pre trade and only risk £10 and I know if I had £1000,000 I would be getting £20,000-£30,000 pre trade which is a lot aha but would traders really stick to this rule of risking 1% if you had an account this large ?

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In 2015, a paper called “Traits of Successful Traders” was published by FXCM.

One of the traits discussed was the ability to use leverage effectively.

“Profitability declines substantially as effective leverage increases: 40% of traders using an average effective leverage of 5:1 or lower turned a profit while **only 17% using 25:1 or higher closed at a profit.”

"Given the relationship between profitability and leverage, you can see a clear link between average equity used and trader performance. At the low end, a mere 21% of traders with $1,000 equity turned a profit.

Those with more than $10,000 in equity were more than twice as likely to see profits. Those with under $1,000 in equity used an average of 28:1 leverage, while traders with more than $10,000 used an average of 5:1."

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Very few traders with £1,000,000 accounts are primarily trading spot forex against counterparty market-makers.

Very few traders with £1,000,000 accounts are using position-sizing anything like as high as 1% per trade. For many reasons, there’s generally an inverse proportionality between account-size/capital-size and position-size.

Your results from a £1,000 account are nowhere near scalable to a £1,000,000 account. Slippage alone would be a huge issue.

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73bbbd2c6b2751ccbba5bfa06d675e5c--quotes-on-money-investors.jpg736×585 44.8 KB

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Hmmm intriguing, so other than position size differences between the two different account sizes, what else would big differences between the two accounts? Because you mentioned about slippage could you explain more please.

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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.

Besides which, with an account that size, you wouldn’t be trading spot forex against a counterparty at all - you’d be using a genuine broker.

Absolutely no criticism implied at all, but I think your questions arise through lack of experience of brokers, and how the market really works.

Position-sizing (expressed as a percentage of account-size) decreases as account-size increases.

Respectfully, your question about whether someone with a huge account would “still only” be trading 1% of their account as their position-size is unrealistic: they wouldn’t be trading anything like as much!

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It is a common sensible approach to risk management that has some roots in the theory of gambler’s ruin. Gambler’s ruin - Wikipedia.

Making a long story short, 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. @eddieb point seems a bit extreme but highlights the point perfectly. You could be trading with and R:R 1:1 and a system with a 60% probability of winning. However if you risked 100% of your account balance and happened to lose that in the first trade (with 40% probability) then that would be the end of the game for you.

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just letting you know. i am saving this photo and i am going to use it as a wallpaper. its the greatest thing i have heard today.

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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)

  1. 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?

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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

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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.

slippage stats 4-11-2018 2-27-11 PM.jpg912×399 70.5 KB

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

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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?

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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 :grin:. 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

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