Trading is a Game of Risk – some forex traders acknowledge this, and others ignore this fact. As I mentioned in the last post, most of the traders in the Market Wizards book had an experience in which this lesson was learned. I believe that your success as a trader will depend upon how you approach risk.
If you decide to approach trading as a job, and manage risk carefully, you are likely to do the following:
- Calculate your risk for each trade. This is a great clue for you, if you are calculating your risk for each trade in your testing and live trading, you are taking a huge step toward successful, consistent trading. If you have any questions about this, try this experiment with your favorite trading system. Open up a demo account and take 25 trades according to your system on the 5 minute and 4 hour chart (50 trades in total). Use the same lot size on the different time frames. Did your system make money overall? Now take another 50 trades (25 on the 5 minute chart, 25 on the 4 hour chart), but this time calculate your lot sizes so that you risk the same percentage on each trade. Did your system make money overall? Why do you think the results varied?
- Risk less than 3% per trade. Most traders have a difficult time sitting through a drawdown. I do. You probably do also. This only becomes more difficult when the drawdown is more severe. If you risk 1% on each trade and have seven consecutive losing trades, you will have a drawdown of less than 7%. This is not so bad. If you risk 5% on each trade and have the same run of bad luck – seven consecutive trades – you will be down more than 30% on your account. Most traders will freak out at this point. Most traders will either a) stop trading, b) switch trading systems, or c) increase the risk even more in attempt to make the money back. Risking less than 3% will increase your chances of survival as a trader considerably.
- Consider all factors in your trading system. Many traders consider the reward to risk ratio of a trading system, likewise, many traders consider the win rate of a trading system. Fewer traders consider the impact of the average win and the average loss (although technically the reward to risk ratio incorporates both average win size and average loss size). And even fewer traders still think about the sequence of trades – in other words, how luck is also responsible for your trading results. What will happen if you have 9 consecutive losing trades? Will you change your trading strategy? What will happen if you have 12 consecutive winning trades? Will you change your trading based on this incredible run of winning trades? The impact of the random sequence of winners and losers is often overlooked, but it is an important aspect of trading. Perhaps you should think about how you might change your trading if you have a large run of losing or winning trades.
In the next post we will talk about pigs and trading, until then – Happy Trading!