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Lesson 5: Risk and Money Management

Lesson 5: Risk and Money Management

The main reason risk and money management are so essential in online trading is this: Your losses hurt you more than your gains help you!

Risk and money management are key to survival as a trader like it is in life. You can be a very skilled trader and still be wiped out by poor risk and money management. Your number one job is not to make a profit, but rather to protect what you have. As your capital gets depleted, your ability to make a profit is lost. Here is everything you should know about risk and money management, presented together because they are intimately related.

How to use this guide

To get the most out of this guide, it’s recommended to practice putting these risk and money management strategies into action. The best risk-free way to test these strategies is with a demo account, which gives you access to our trading platform and $50,000 in virtual funds for you to practice with. Get your free demo account.

Once you’ve found a strategy that consistently delivers positive results, it’s time to upgrade to a fully funded live account where you can apply your newfound edge.

What is Money Management?

Money management is about ensuring that loss per trade is small relative to your total account size. Small losses of about one to three percent of your total account are survivable and possible to recoup, large ones are not easy to get back, and repeated large losses will destroy your account and confidence.

What is Risk Management?

Risk management is about keeping losses small relative to your gains. Because even successful traders commonly experience a high percentage of losing trades, your goal is to keep losses from losing trades low relative to the gains from winning trades, so you can be profitable with fewer than 50 percent of your trades being profitable. That is what risk management involves.

Why do traders need risk and money management?

The main reason risk and money management are so essential in forex trading, stock trading, or cryptocurrency trading lately is this: Your losses hurt you more than your gains help you!!!

That’s not just because of the damage losses do to your confidence and motivation. After you suffer a drawdown, you’re working with a smaller principal.

For example, let’s say you online trading with $1,000.

  • If you lose 20 percent, you will need to earn 25 percent on your remaining $800 to recover your losses.
  • If you lose 50 percent, you will need to earn 100 percent on your remaining $500 to get back to $1,000.
  • If you lose 90 percent, you will need to earn 900 percent on your remaining $100 to get back to $1,000.

Though profits are the goal, it’s the losses that can stop you from achieving it. Because even successful traders commonly experience a high percentage of losing trades, your goal is to keep losses from losing trades low relative to the gains from winning trades, so you can be profitable with fewer than 50 percent of your trades being profitable (risk-reward ratio of 1:3 or at least 1:2).

The Essence of Good Risk and Money Management

To be motivated to practice good risk and money management, you first need the right mindset. Risk and money management is all about the following, which we cover in detail in CAPEX Academy:

  1. Trading with more conservative styles and methods.
  2. Making sure your gains from winning trades are larger than your losses from losing trades.
  3. Increasing the odds of favorable risk-to-reward ratios.
  4. Preventing a fatal loss from one or a series of losing trades from which you’re unlikely to recover without adding funds.

The Three Pillars of Risk and Money Management

The size of this maximum allowable loss per trade depends on three conditions:

  1. Account size: Determines the cash value of the 1 to 3 percent maximum loss you can afford. Thus, it determines how far you can set your stop-loss orders from your entry point. The larger the account, the wider the stops you can afford, and the more choices of trades you have available to take. For a given trading account size the maximum loss you can safely afford is a function of the following two factors:
  2. Stop Loss: Pre-define the potential loss you accept in each trade. The wider the stop loss, the smaller the position size (or volume) you can afford without exceeding that 1 to 3 percent. The tighter the stop loss, the larger the position size (or volume) you can afford without exceeding that 1 to 3 percent. Remember that stop-loss orders are used only to limit losses as price is not guaranteed in abnormal market conditions.
  3. Position size: Determines the cash value of each pip or point. For a given account, the larger the lot size used, the more every pip or point moves against your costs. The larger the lot size, the higher the risk and profit potential.

Let’s look at these in greater detail. All focus is on ensuring that your stop-loss setting doesn’t risk more than 1 to 3 percent of your capital and that gains per winning trade are much larger than losses per losing trade.

Money management calculation

Step 1 - Set Your Account Risk Limit per Trade

This is the most important step for at least having a chance to succeed, even for smaller, realistic returns. Any returns! Without it, failure is guaranteed before even starting.

Set a percentage or dollar risk limit, you'll risk on each trade. Most professional traders risk 1 to 3 percent of their accounts balance or equity if other trades are open.

For example, if you have a $1,000 trading account (equity, not balance), you could risk $10 per trade if you risk 1% of your account on the trade. If you risk 2%, then you can risk $20. You can also use a fixed dollar amount, but ideally, this should be below 2% of your account. For example, you risk $15 per trade. If your account balance goes to $985, then you'll be risking 2% or less. While other variables of trade may change, account risk is kept constant. Choose how much you're willing to risk on every trade, and then stick to it. Don't risk 5% on one trade, 1% on the next, and then 3% on another. If you choose 2% as your account risk limit per trade, then every trade should risk about 2%.

Step 2 - Determine Pip/Point Risk on Trade

You know what your maximum account risk is on each trade, now turn your attention to the trade in front of you.

Pip/Point risk on each trade is determined by the difference between the entry point and where you place your stop-loss order. The stop-loss closes out the trade if it loses a certain amount of money. This is how risk on each trade is controlled, to keep it within the account risk limit discussed above.

Each trade varies though, based on volatility or strategy. Sometimes a currency trade may have five pips of risk, and another trade may have 15 pips of risks. When you make a trade, consider both your entry point and your stop loss location. You want your stop loss as close to your entry point as possible, but not so close that the trade is stopped out before the move you're expecting occurs.

The following rules on stop loss setting assume you’re going long near strong support level or short near resistance level because if you aren’t, you shouldn’t even consider entering the trade. If the trade moves against you, that nearby key level is quickly breached and you have a signal to exit before a small loss becomes a large one.

When setting your stop-loss order, you’re always striking a balance between two conflicting criteria:

  1. The stop-loss price is close enough to your entry point so if it’s hit, the loss doesn’t exceed 1 to 3 percent of your account value, as noted previously.
  2. It’s far enough away from your entry point and the likely support and resistance levels so it doesn’t get hit by normal random price movements and close your position before the price has had time to move in your favor. Rather, it’s triggered only by price moves that are big enough to suggest that you were wrong and overestimated the strength of a given key zone, and now a loss is more likely than you thought. It’s time to close the position before a small affordable loss becomes a large one. There are different ways to determine the normal or average price movement to expect during a given period. Some manually determine the average or typical candle length over a given period. Some will use a certain percentage of the range as determined by the Average True Range (ATR) indicator. Price volatility varies with market conditions and time frame as must the distance from the entry point to stop loss.

Once you know how far away your entry point is from your stop loss, in pips, you can calculate your ideal size for that trade (step 3).

Let's take our example into consideration, and recap the above:

  • Risk management criteria: Aim for a 1:3 risk-to-reward ratio. In other words, the distance in pips from our entry point to stop loss should be no more than about a third of the distance from our entry point to our profit-taking point (near the high in the case of long positions, near the low in the case of short positions). That way our winning trades produce gains that make up for multiple losses.

In other words, each successful trade should bring you at least 3x2%= 6%.

Favorable risk-reward ratios are another key part of good Risk and Money Management. We seek 1:3 risk-reward ratios (aka 3:1 reward-risk ratios, same thing) or better, though we will certainly consider trades with 1:2 risk-reward ratios, as shown in our Risk-Reward Ratio guide. That way your winning trades bring gains x3 the size of your losses. That allows you to be profitable with an achievable winning trade percentage of just over 25 percent.

Play smart with your Stop Loss (manually or using a Trailing Stop Loss):

  • first, move your Stop Loss to the entry point (breakeven) so that you make sure you avoid a loss, once the trade makes a decisive move in your direction (or at least your floating profit equals your initial risk of 2% in value)
  • then, move your Stop Loss to positive territory, locking in at least 2% that can cover the next loss.
  • continue to maximize profit using the above logic.

Remember, with a 1:3 risk-reward ratio, as long as you’re right more than 27.5 percent of the time, you’ll be profitable.

Step 3 - Determine the Lot Size

Position size is usually the easiest one to keep your maximum loss risked per trade in control and, at times, is the only one. Your position size is how many lots or contracts you take on a trade. Position size is a simple mathematical formula equal to:

  • Pips/Points at Risk X Pip/Point Value X Lots traded = $ at Risk.

We already know the $ at-risk figure, because this is the maximum we can risk on any trade (step 1). We also know the Pips at risk (step 2).

All that leaves us to figure out is the lots traded, which is our position size. Assume you have a $1,000 account and risk 2% of your account on each trade. You can risk up to $20, and see a trade in the EUR/USD where you want to buy at 1.3035 and place a stop loss at 1.2995. This results in 40 pips of risk.

You can use a lot size calculator or do some manual calculations. Your 40 pips stop loss should generate not more than $20 loss. So your position size should be a maximum of 0.05 lots (or 5 micro lots).
CAPEX WebTrader allows traders to set stop loss orders in four ways: price level, number of pips, the cash value in account currency, and percentage.

risk and money management

A final word about Risk and Money Management

In light of the above, if you’ve got a professional mindset, you’ll be serious about risk and money management. Theoretically, they’re separate, but in practice, you apply them together and both are essential for your survival while you are learning and finding yourself as a trader or investor.

While risk management is about keeping losses small relative to your gains, money management is about ensuring that loss per trade is small relative to your total account size. Small losses of about one to three percent of your total account are survivable and possible to recoup, large ones are not easy to recoup, and repeated large losses will destroy your account and confidence.

Free trading tools and resources

Remember, you should have some trading experience and knowledge before you decide to trade online. You should consider using the educational resources we offer likeCAPEX Academyor ademo trading account. CAPEX Academy has lots of courses for you to choose from, and they all tackle a different financial concept or process – like the basics of analyses – to help you to become a better trader.

Our demo account is a great place for you to learn more about leveraged trading, and you’ll be able to get an intimate understanding of how CFDs work – as well as what it’s like to trade with leverage – before risking real capital. For this reason, a demo account with us is a great tool for investors who are looking to make a transition to leveraged trading.

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