Risk management during the trade can be applied by using risk/reward ratio. Drawdown and losing streak are the two things that you should keep an eye on if you want to last long as a forex trader.
In the previous article we have talked about three things you should do to manage your risks even before you started trading forex. In this second part, we are going to talk about managing your risks along the way. There are three points you are going to learn here, those are the concept of risk/reward ratio, drawdown, and losing streak.
Risk/Reward Ratio is a ratio used by traders and investors to measure the amount of expected profits they are going to gain from a certain trade/investment (reward) compared to the risk of the said trade/investment. In order to make profitable trade, you should ensure that the level of reward is higher than its risks.
The table above shows us a risk/reward ratio of 1:3. Although the trader was only profit in a third of his trade, but overall, he still managed to produce 10,000USD. Not bad, isn't it!?
The use of money management will improve your profitability. But to know how effective your money management is, you should know your drawdown percentage. Drawdown refers to balance account shrinks after a series of transactions. There is also maximum drawdown, where the shrinking balance account is counted over a certain period. The picture below illustrates maximum drawdown of an account.
No matter how sophisticated the trading strategy you use, possibility of losses is always present. A strategy with 70 percent profitability means that in 100 transactions, there is 70 wins and 30 losses. But is that meant in 10 transactions, there will be 7 wins and 3 losses? Certainly not. It is possible that in that 100 transactions, the first 30 was losses, and only after such long journey, winnings happened. Money management makes it possible for traders and investors alike to make profits even after such losing streak.
In the picture below, we could see the difference between a trader who uses 2% risk rule and one who puts in 10% risk on each trader.
Although both of them has the same 20,000USD start up and suffers 19 losing streak, there is a difference in how much funds left in the balance. The one who uses 2% risk rule still has 13,903USD, while the other only has 3,002USD left in his account.
To recover from losing streak and reach breakeven point, you have to produce more profits. The more losses you suffered, the more profits you should make. That's why, you have to be really sure in counting how much losses you could bear before you make the trade. To simplify the calculation, you can use the money management calculator that can generate recommended lot sizes, stops, and targets based on your trading rules.