I’m well aware of the rule to never - at least for a newbie - invest more than 1-2% of one’s account in a trade. But suppose a trader has found a winning strategy, earning a regular overall net profit. If he should venture into opening multiple trades, especially in diversified currency pairs, what would you say the maximum total per cent of his account should be in his trades at any given time? 10%? Some other %?
Your thoughts and insights would be greatly appreciated.
I think the 2% rule applies equally well for experienced traders as it does for newbies. The more you learn about trading, the more trading ideas you should have to spread your risk. Why put all your eggs in one basket?
I never go over 2% per trade and I try not to have too many trades open at one time. However, If I see a good trade opportunity I will take it. I try not to let myself go over 5% of my account at risk at any moment, but that is just a personal preference. The answer is whatever risk you feel comfortable taking is what you should limit yourself to. Sometimes my trades are only .5% if I don’t feel particularly confident in the move I’m trading. Other times I put 2% down on a pair and 2% down on a related pair. You have to have a feel for what you are willing to risk personally.
I stick to 2% per trade because anymore than that gets tough to earn back. Some traders never risk more than 1% per trade for similar reasons. Some traders will risk much more than that per trade. I’ve found that taking a few consecutive losses makes you learn your personal risk level pretty quickly.
first of all, I think you have to categorize traders. Not all traders are the same. Short-term scalpers differ a lot from swing traders, and swing traders differ a lot from position traders. If we have a look at the short term scalper - they might take 20-30 trades a day, and they might have a general win ratio of less than 50% but their risk/reward might be 2:1 or even 3:1, so at the end of the day, week or month they should be profitable. If we look at it mathematically, short-term scalpers with a win rate of 50% have a high risk of incurring a 19-20% drawdown every two months. How did I get that number?
A short term scalper with a win/lose rate of 50% has a 50/50 of losing each trade he or she takes. What’s the likelihood of that scalper to have 10 losing trades in a row? Well, let’s take 0.5^10, which equals a very small number. If we divide 1 by that small number, we know that the scalper would have to take 1024 trades in order to have a losing streak of 10 trades. If he takes 20 trades PER DAY, that means there’s a 100% likelihood that the scalper will have such a big losing streak every 51 days. If he were to risk 2% per trade, that would mean his account equity would drop 20% (if you include commission costs etc) over the course of those losing trades.
Now let’s look at a position trader. Let’s say the position trader also has a 50% win rate but only takes 5 trades per year. How long does the position trader have to trade for there to be a 100% likelihood of him incurring a losing streak of 10 trades? It would take him 204 years! So you see, a position trader can comfortably trade with higher risk per trade than a scalper. You also have to remember that position traders only take the best setups they see (at least the better ones!) and they know they might not get any good trade the first 6 months of the year, but the latter half of the year their 5 trades might setup and they might profit big. Position traders generally also have a much higher win rate of 50% - I’d say it’s normally upwards of 70-80%, which means a trader taking 5 trades per year should win at least 3 of those trades with a good risk/reward. I’m just trying to speak in general terms and compare a professional scalper to a professional position trader, so I hope it provides some insight and opens up new ways for you to think about risk/reward, win ratios and such!
I’ve bolded the key factor in the question. It is actually hard to trade in diversified pairs in the forex market.
First, as soon as you have pairs with a currency in common (e.g. EUR/USD and USD/JPY) you have a correlation. And if you take opposing positions in the common currency (long EUR/USD and long USD/JPY mean short USD on the one hand and long USD on the other) you get into a situation where you’re creating synthetic cross rates, which is actually costing you money because of the added bid/ask spread.
Second, even if you don’t have a currency in common you might have a correlation on a fundamental or market psychology basis. For example, the EUR and GBP may trade similarly at times because of common economic or political factors. Alternately, the USD and CHF may move in parallel when the market is in a risk aversion mode. This is something you really need to be alert to because the causes of these correlations aren’t always apparent and can develop/change quickly.
That doesn’t leave you with a lot of options to have diversified pairs. If you actually manage it, you probably won’t have too many common signals - and if you do then it might be time to wonder why.
I try to limit myself to “6%”. It’s a loose figure. Big news events will usually push most pairs in one direction.
If you’re concerned about correlation, try to reduce your reward and/or stop loss. This way your trades will end quicker, allowing you to trade more signals as they come up.
You raise a good point. My primary strategy trades all 10 crosses of these 5 currencies: USD, EUR, JPY, GBP and AUD. So if this strategy is short EUR/USD, long USD/JPY, short GBP/USD, and short AUD/USD then it is long US dollar across the board. While this happens sometimes, it’s usually the case that the strategy is long USD on some pairs and short USD on others. The goes for the other 4 currencies.
Since I started this thread, I thought I’d turn you on to an Investopedia article, “Limiting Losses,” which includes The 2% Rule and the Monthly Loss Limit of 6% Rule. Seems like it can be applied to simultaneous trades that total more than the 2% rule for individual trades. It’s at Limiting Losses.
Thanks for all your comments - and keep them coming. I’m still learning.
“So you see, a position trader can comfortably trade with higher risk per trade than a scalper.”
Thank you for the math and the insights! Pretty good math for a newbie! Replies such as yours are causing me to shift my probable initial orientation to swing trading rather than scalping.
I replied to all of you, but some of my replies seem to have disappeared. I want you to know that I have read your replies carefully, and have even copied choice sections to my personal notes.
In addition to limiting the amount you risk per trade to 2%, you will also want to take into account currency correlations as Rhodytrader already pointed out. That’s not to say that you should avoid trading correlated currency pairs entirely, but you should be aware of these correlations and try to diversify with some uncorrelated pairs as well.
