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Undergraduate Senior – Advanced Online Forex Trading Course

What Is Risk Management? Drawdown and Maximum Drawdown, Reward-to-Risk Ratio

What Is Risk Management? Drawdown and Maximum Drawdown, Reward-to-Risk Ratio

Learn All About Risk Management

What Is Risk Management? Drawdown and Maximum Drawdown, Reward-to-Risk RatioRisk management is a topic that you will find in many industries including trading. The reason why this topic is so crucial is that in the forex market, you are there to make money and making money involves risk of potential losses.

Trading is a highly risky activity and risk management is something that is, unfortunately, ignored in this area. A lot of new traders are just ambitious and get straight into trading without assessing the potential risks. This is not trading but a tryout of luck.

Risk management principles are designed to help you in the long-run rather than the instant jackpots that no doubt look attractive, but comes at a huge risk which most traders cannot afford or would not want to afford.

In the world of trading, if you learn to control your losses, you are at a greater chance of being successful. Forex trading is a number game after all and you have to do whatever you can to turn the tables in your favor.

Being a forex trader, you would like to become a rich statistician and trader and NOT a gambler looking to make short term quick profit. Focusing on the long-term goals is the key here that can make you the winner you always wanted to be.

How Much Trading Capital Do You Need For Forex Trading?

Money does not come easy! Either you put hard work or money to make money. Simple as that!

Forex trading requires trading capital. But what amount of trading capital is required to start in forex trading? The answer to this question is dependent on a lot of factors including your approach towards your new business. When it comes to forex trading, there are many different ways or approaches to learning how to trade. You can join classes, find a mentor, learn on your own, or create a combination of all three.

However, you should know that mentors and classes are not free. It is also a fact that a mentor or a class will significantly reduce your time of learning and get you through the earning phase much quicker than you would expect from doing it all by yourself.

Besides the benefit of learning quickly, it is also essential to introduce to the drawbacks of these programs. The biggest of them is the upfront cost of these programs that may range from a few hundred to even a thousand bucks, depending on the mentor or class you choose.

A lot of new traders don’t have the resources or money to purchase any of these programs. The good news for such people is that today, most of the information is available on the internet. You can easily find articles, forums, websites, and brokers having all the information you need to learn.

In the world of forex trading, it is your discipline, focus, and willingness to learn besides trading capital that can take you places. Your success depends largely on your knowledge of the market. The more you learn, the better you earn.

One thing you should also need to know is whether or not you require any tools news feeds or charting software. Being a forex trader, the charting packages that come with your trading platform or brokerage, are good enough to start with. If you want better indicators or software with enhanced charting, can start around $100 per month.

If you are enthusiastic about forex trading, maybe you would want to get the news the second it is released. Well, getting news at such a snap of time require thousands of dollars per month, which does not seem to be a good idea early on in your career.

Again, you can easily get news from your forex broker but after a few seconds. These few seconds can also define a successful or unsuccessful trade.

Last, but definitely not the least, you need trading capital i.e. the amount required to start trading. Retail forex brokers offer minimum account deposits of as low as $25. Having said that, it does not mean that you let loose of your horses. In order to earn big, you should invest big.

So how much trading capital do you exactly need?

Honestly, if you follow proper risk management techniques, you should probably start with $50k to $100k at least in trading capital.

In the world of forex trading, a lot of businesses fail because of undercapitalization. Don’t lose heart, if you are unable to start today; wait, save up some money, and start when you are financially strong and ready to go.

Drawdown and Maximum Drawdown Explained

All You Need to Know about Drawdown and Maximum Drawdown

Drawdown and Maximum Drawdown ExplainedAs we all know, applying risk management techniques can help us make money in the long-run. However, it is always good to know the other side of the coin.

What would happen if you don’t apply the risk management principles?

To make it easy to understand for you, let’s take the help of an example.

Let’s say you have $170,000 and you lose $85,000. How much percentage of your account have you lost? 50%, that’s right!

It is as simple as that! This is what traders call a drawdown.

When a trader’s capital reduces after a series of losing trades, it is called a drawdown. It is usually calculated by getting the difference between a relative peak in capital less a relative trough.

Losing Streak

In forex trading, we are looking to gain an advantage. This is the reason why systems are developed by traders.

A trading system that is 80% profitable does not mean that you win 8 out of every 10 times. Even though it does, how would you know if those 8 trades out of 10 will be winners?

The answer is that you cannot predict which trade is going to be profitable. You may win the first 8 trades but go on to lose the remaining 2. Imagine if you have invested more in the last two, the loss will be mighty big than the profit of the early 8.

This is where risk management comes to the rescue.

Drawdowns are an Integral Part of Trading

The most important part of being a trader is to come up with a trading plan that enables you to get over or completely avoid the heavy losses. The best way of doing that is by following risk management practices. Always risk a small proportion of your trading capital to make sure you survive the losing streak.

If you follow strict money management rules, you are more likely to become a gambler and may lose in the long-run. In the next session, we shall discuss the outcomes of using and not using proper risk management.

Never Risk More Than 2% Per Trade

It is often asked how much to risk per trade.

First of all, it is a great question and there’s nothing wrong about it considering trading is a risky activity.

Experts suggest limiting the risk to 2% per trade.

It can be a little high for new traders.

Let’s take the help of an illustration to show you the minor difference between risking a small percentage of your trading capital as compared to risking a higher proportion.

Risking 2% vs. Risking 5%

Trade No. Trading Capital 2% Risk on Each Trade Trade No. Trading Capital 5% Risk on Each Trade
1 $20,000 $400 1 $20,000 $1000
2 $19,600 $392 2 $19,000 $950
3 $19,208 $384 3 $18,050 $902
4 $18,824 $376 4 $17,147 $857
5 $18,447 $369 5 $16,289 $814
6 $18,078 $362 6 $15,475 $773

 

From the above table, it is quite evident that there is a big difference between risking 2% of your account compared to risking a higher amount i.e. 5% in this case on a single trade.

If you happened to go through a losing streak and lost 6 trades in a row, you will lose around $4,525 of your trading capital at 5% risk per trade.

This accounts for losing 22.65% of your trading capital, which is huge!

The contrary of it, if you risked only 2% of your trading capital per trade, you would have still had $18,078 after a losing streak of 6 trades.

This figure is huge as compared to the one left after losing 6 trades.

The idea of this example was to help you devise your own risk management rules so that when you have an unfortunate drawdown period, you have enough capital left to survive in the market.

What would happen if you lose around 22% of your trading capital with just 6 trades? That means in order to get back to the original position, you should make a lot of money to recover your lost amount to get back to the breakeven point.

Losing money is easy but making the recovery of it is not! Try to use your risk management principles to make sure you are always on the winning side and the risk of losing money is at the minimum possible level. Remember, you have to think long term and not short term!

Reward-to-Risk Ratio

In order to increase the chances of making good profits, you should have the ability to trade more than 3 times what you are risking.

For that purpose, you have to give yourself a reward to risk ratio of 3:1 to earn profits in the long run.

Example

Let’s discuss the following chart as an example:

6 Trades Loss Win
1 $500
2 $1,500
3 $500
4 $1,500
5 $500
6 $1,500
Total $1,500 $4500

 

In the above example, you can see if you lose even 50% of your trades, you can still make a profit of $3,000. All you have to remember is that when you are trading with a better risk to reward ratio, you have much better chances of making good profits compared to a lower reward to risk ratio.

Applying a good reward to risk ratio may seem a good idea but it is not a walk in the park. Let’s say you are a scalper and you wish to risk 2 pips. Using a 3:1 reward to risk ratio, you need to get 6 pips. The odds may seem against you but you have to pay the spread. Please note that you need to get 8 pips if your broker offers a 2 pip spread on EUR/USD. Similarly, if you want to reduce your position size, you have to widen your reward to risk ratio.

If you want to increase the number of pips you want to risk, say 60, you would need to gain 162 pips. In the real trading world, the reward to risk ratios is not hard and fast rules. They should be adjusted with time considering the market condition, trading environment, and other factors.

Warp Up

Be the game, not just a player in the game! Always remember that focusing on long-term goals is the way to go.

You have to invest money if you want to make money. It is as simple as that. How much money do you need to invest to start forex trading?

It greatly depends on your business approach and your objectives. This is the reason why the answer may differ for each person. Drawdowns are natural and happen to everyone at some point in the trading career.

It becomes harder to bring your account back to its original size once you start losing money. This is the reason why you need to do whatever you can to protect your trading capital from the risks.

Always risk a small percentage of your trading capital because the more you risk, the harder it gets to make the recovery to get back at breakeven.

Large drawdowns are always threatening to your trading account and your career as well that can make your survival difficult. The less you risk, the less the drawdown will be and vice versa.

Keeping the risk at 2% per trade is highly recommended for everyone.

Being a big match player should be your goal rather than a dashing hard hitter. We emphasize guidelines because the experience may let you down at times but doing the basics right will not.

3 Comments

  1. Anish Niraula on August 16, 2019 at 2:06 AM

    very useful chapter for me

  2. Raju Acharya on August 24, 2019 at 7:32 AM

    Little

  3. Harmanjot Kaur on August 15, 2020 at 3:46 AM

    very use full chapter

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